Are smart betas the intelligent choice?

There might well be more than one way to skin a cat (I have not tried), but there is certainly more than one way to go ‘passive’.

As a reader kindly noted in the letters pages of Financial Adviser recently, there is no reason why investors should be subject to a variant of Mr Ford’s “any colour as long as it’s black”. If I want to invest in the UK stock market, the choice should not be limited to the FTSE 100 through full replication, the FTSE 100 through sampling, or the FTSE 100 through swaps. All give you, with differing risks, basically the same exposure, and therefore do not offer a real choice.

There are reasons why simplistic passive products are popular, although some of these have more to do with what is beneficial for the providers than what is helpful for the client. A FTSE 100 tracker, for example, is very simple to create – even a full replication product needs to only buy 100 highly-liquid names. While UK stamp duty does make full replication indices for the UK market more expensive, the profit margins on any passive product only tracking 100 names can be very high. Importantly, liquidity also means that the product is very scaleable – many billions of assets can be readily invested. Since capacity is often one of the major constraints on active management’s profitability – that is, funds closing to protect performance impedes growth in profitability – large cap indexing is unsurprisingly attractive from a potential growth of profit perspective.

If an investor really wants exposure to, say, UK equities, would it not make more sense to have broader market exposure? The composition of the FTSE 250 mid cap index is very different to its FTSE 100 large cap brother. Why not a FTSE 350 tracker? They do exist, although interestingly, in my experience, tend to be less popular. Perhaps one of the reasons is that the FTSE 100 dominates the 250 and, (as per my index concentration comments a few articles ago), a few mega caps dominate the whole 350, and so diversification, when so ‘watered down’ by this large cap dominance, does not seem worthwhile.

Perhaps, therefore, a different approach makes sense. Equal-weighted indices typically create a higher level of absolute volatility, since they assign greater weights to smaller capitalisation, and generally higher volatility, names than a capitalisation-weighted index. An equal-weighted FTSE 350 index, for example, would have just under 0.3 per cent in each stock – a very large underweight to the mega caps, but a very large overweight to the lower end of mid-caps. Such a passive strategy would certainly overcome the mega cap bias and narrow focus of traditional indexing, but would also have a level of absolute volatility that some investors would find uncomfortable.