Smart beta: I can’t believe it’s not beta

Investors using ‘smart beta’ products need to understand the risks

Smart beta: I can’t believe it’s not beta

There is a strong argument that smart beta is neither smart nor beta. That doesn’t necessarily make it a bad thing. Maybe it’s just badly named. For some investors smart beta means a passive strategy. Others view it as active. The confusion around the label shouldn’t get in the way of understanding the risk and return characteristics of what is on offer and assessing whether it fits with an investor’s objectives.

What is beta?

In investment terms, beta means the entire market. Passive funds, also called index funds, replicate the market by investing in each constituent of the index in proportion to its size. Let’s say a UK bank, measured by the total value of all its shares, made up 1% of all the shares represented in the FTSE All-Share Index. An index fund would maintain its holding of the bank as close to 1% of the fund.

The total value of a company’s shares is called its market capitalisation, and this approach to constructing an index fund is called market-cap weighted. Funds constructed in this way often tend to be significantly cheaper than active funds, where the fund manager picks a selection of shares that he or she hopes will outperform the market-cap weighted return.

Can beta be smart?

Smart beta is not beta because it does not attempt to replicate the whole market’s performance. A smart beta fund identifies one or more characteristics of the investment universe and then selects securities that display those characteristics.

For example, a commonly identified characteristic for equities is a history of paying dividends at a given level. Other characteristics often used in constructing equity smart beta funds include revenue, assets, free cash flow and valuations. Among the valuation metrics are such measures as the share price relative to the company’s earnings (its P/E ratio) or the share price relative to the book value of its assets.  This approach is not just for equites. Smart beta bond strategies look at characteristics such as debt levels relative to gross domestic product (GDP) for sovereign bonds, or to cash flow and assets for corporate bonds.

These characteristics are sometimes referred to as factors and this approach to smart beta is known as factor-based investing. Each of these factors is a valid way of differentiating between potential investments. It may be that an investor’s investment philosophy leads them to believe that a certain style, such as value investing, is the key to meeting their investment goals. If so, then a suitable factor-based approach could be the right road for them to take if they understand the risks associated with that particular factor.

Active or passive?

But investors in smart beta funds should be aware that they are no longer buying the market as a whole. That is something that can only be achieved through a market-cap weighted fund, a fund that replicates the entire market.

As a result factor-based investment funds are likely to deliver returns that are different from the market. In this respect, they are not passive, as defined above, but an active investment. It is an active decision to favour only securities of a certain type, such as those that consistently pay dividends or have low levels of debt.

Factor-based funds tend to prefer characteristics that are clearly identifiable, in particular those that can be reduced to quantifiable ratios. A company’s accounts are a matter of public record, as is its share price. The two can be put together to form a price-earnings ratio. Favouring companies that have a low valuation makes for a clear and comprehensible approach. But will it always meet an investor’s objectives?

Focus on investment objectives

Investment objectives should help inform an investor’s asset allocation. In some cases, factor-based investment strategies will be part of that allocation. In many others, a market-cap weighted approach is likely to provide the most effective exposure.

In our view, factor-based funds can play a role in portfolios. They offer investors an array of opportunities at a relatively low cost. But it is important to remember that although these funds are marketed as beta, they do not represent the whole of the market. They will inevitably slant a portfolio’s returns away from the market, and that may be fine as long as investors understand the different risks they are taking.

Investors need to be comfortable with the idea that smart beta doesn’t mean outsmarting the market. Sometimes these strategies will outperform it and sometimes they will underperform it. The key to investment success is not trying to beat the market. Rather, it is choosing investment strategies that are appropriate for an investor’s long-term investment objectives.

 

Important notes

This article is designed for use by, and is directed only at persons resident in the UK.

The material contained in this document is not to be regarded as an offer to buy or sell or the solicitation of any offer to buy or sell securities in any jurisdiction where such an offer or solicitation is against the law, or to anyone to whom it is unlawful to make such an offer or solicitation, or if the person making the offer or solicitation is not qualified to do so.

The information in this article does not constitute legal, tax, or investment advice. You must not, therefore, rely on the content of this article when making any investment decisions.

The value of investments, and the income from them, may fall or rise and investors may get back less than they invested.

The opinions expressed in this article are those of individual author and may not be representative of Vanguard Asset Management, Limited.

Issued by Vanguard Asset Management, Limited which is authorised and regulated in the UK by the Financial Conduct Authority.

© 2015 Vanguard Asset Management, Limited. All rights reserved.

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Categories: Analysis, Funds

About Author

Nick Blake

Nick Blake is Head of Distribution, Europe, Vanguard.