A growing number of investors are looking toward strategic beta additions to their portfolios. Reasons cited include means to manage risk, enhance returns, tactically adjust asset allocations, portfolio completion, fee reduction, and a general disillusionment with active managers.
Strategic beta, sometimes known as “smart beta”, refers to a rapidly growing category of benchmarks and the investment products that track them. The common thread between these products is that they either seek to improve returns or alter their risk profile in relation to more traditional market benchmarks.
There were 667 strategic beta exchange-traded products (ETPs) with collective assets under management (AUM) of approximately $417bn (£266bn) as of 31 October 2014, according to the latest Morningstar data.
Managed by BlackRock, iShares is the largest provider of ETPs with 46 per cent of market share and €166.4bn (£132.9bn) AUM. The second largest provider, db X-trackers, is roughly a quarter of the size of iShares with €42.6bn (£34.0bn) AUM and 11.8 per cent of market share. In third place is Lyxor with €38.0bn (£30.4bn) AUM and 10.5 per cent of market share.
An exchange-traded fund (ETF) is a type of strategic beta. It is an open-ended fund that replicates the performance of an index or a strategy. ETFs trade on an exchange and allow investors access to virtually all asset classes at a low cost, and can be bought and sold within the business day with real-time pricing.
Physical versus synthetic
There are two ways in which ETFs can follow the performance of an index or strategy – physical replication and synthetic replication.
Physical ETFs seek to mimic their index by holding the actual securities included on the index or strategy on which they are based. The physical ETF can be full or sampled.
Full physical replication is often said to be the most reliable approach, but can be difficult to execute for global markets as it requires a great deal of time and effort – and subsequent cost – to conduct all the transactions required to make it accurate.
Sampled physical ETFs invest in a portion of the benchmark that fits with the objective of the fund. This may help to cut the administrative and transaction costs associated with a full replication, but this comes at the expense of a higher tracking error as the fund does not hold all the securities in its benchmark.
Synthetic ETFs obtain their index exposure through over-the-counter swap contracts. As opposed to holding the securities directly to mimic the benchmark, they exchange the performance of the securities with the performance of the reference by holding derivatives. They can hold securities, or have collateral posted, in order to mitigate counterparty risk.
There has been a clear preference in the market for physical ETPs over the past decade, as seen in Table 1. Physical ETFs have comprised around 70 per cent of the European ETP market in the first three quarters of this year.
ETFs in perspective
As assets flow into passive investment vehicles that are increasingly active in nature and implementation, the line between active and passive management continues to blur. ETPs are passive in the sense that they adhere to certain rules, yet active as they bet against a market portfolio. Morningstar has identified a thread of common elements among products that they consider to be strategic beta.
These products are index-based and track non-traditional benchmarks with an active element to them. Many of their benchmarks have short track records and were designed to be the basis of an investment product. Expense ratios tend
to be lower compared to actively managed funds, yet are often slightly higher compared to products tracking “bulk beta” benchmarks, such as the S&P 500.
There are 146 ETFs that fall under Morningstar’s strict strategic beta requirements, of which 66 are physically-replicated and 80 are synthetic. The five biggest of each are shown in Table 2.
The largest ETF is iShares Developed Markets Property Yld – a £1.7bn physical fund. Established in 2006, it tracks the performance of the FTSE EPRA/NAREIT Developed Dividend+ index, which offers exposure to listed real estate companies and real estate investment trusts (Reits) from developed countries worldwide which have a 2 per cent or greater one year forecast dividend yield.
There are 276 holdings in the fund, the largest which is the US-based Reit Simon Property Group at 5.2 per cent of holding. The United States constitutes the largest geographical exposure at 56.8 per cent, with Hong Kong next at 7.9 per cent.
The Ossiam US Minimum Variance NR ETF 1C Eur is the largest synthetic fund. It tracks the performance of the Ossiam US Minimum Varience Index Net Return USD, reflecting the performance of the 250 most liquid stocks from the S&P 500.
Risk and reward
When looking into strategic beta, investors need to weigh the overarching strategic objective of their underlying benchmark, that is, whether the strategy is risk-oriented, return-oriented, or the catch-all “other” classification.
Risk-oriented strategies aim to manage the level of risk compared to a standard benchmark by either reducing or increasing it, as seen in low-volatility and high-beta strategies.
Return-oriented strategies look to improve returns in relation to the standard benchmark, including value and growth-based benchmarks, or to isolate a specific source of return, such as dividend-screened or weighted indices.
Wide arrays of strategies are encompassed by the “other” category, stretching from multi-asset indices to non-traditional commodity benchmarks. This classification allows investors to categorise strategic-beta products along very broad lines.
As strategic-beta products, including ETFs, continue to gain a stronger foothold in the market, investors must examine which category best suits their portfolio’s needs.
Five questions to ask:
1. Is an ETF appropriate?
Proponents of ETFs assert advantages include intraday liquidity and real-time pricing, low cost, access to virtually all asset classes, and that they can be used to achieve many strategies, including the ability to short sell.
2. Synthetic or physical?
Physical ETFs directly hold securities and have higher transparency and limited counterparty risk, but can be tougher to execute due to size. Synthetic ETFs hold derivatives, have lower transparency and higher counterparty risk, but can be more easily executed.
3. What are the risks?
The way an ETF replicates a benchmark can contribute to structural risk. This is especially applicable to sampled synthetic ETFs, as it has a higher tracking error. Take a look into all possible risks before investing.
4. What costs need to be considered?
Holding plus trading costs equal the total cost of ownership. The holding cost for physical ETFs include total expense ratio (TER), rebalancing costs and securities lending, while those for synthetic ETFs includes TER and swap spreads. Trading costs encompass bid-offer spread and brokerage commission.
5. How can you assess an ETF’s tracking quality?
Tracking error takes into consideration the volatility of a fund’s return differences over a period. Tracking difference demonstrates the difference in returns between a fund and its benchmark over time.
