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Guide to smart beta
Your IndustryApr 20 2016

Complications and expense

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Complications and expense

Given the various terminologies being used to describe the same thing (strategic beta, alternative beta and rules-based investing for Smart Beta), and various interchangeable terms for methodology, it is not farfetched to understand how some investors would find this complicated.

For a start, not all indexes on which smart beta products are constructed are built the same, says Dave Gedeon, vice-president and head of research and development for Nasdaq Indexes.

“It’s critical to look closely at the construction criteria. You can find out how the index is constructed by reading the methodology.”

Behind each methodology are factors such as size, momentum, quality, value, factor diversification and tactical rotation - which means investors and their advisers must understand what each of these underlying factors, or rules, mean, and how they can be used in a portfolio.

This means, compared with actively managed funds, Eric Shirbini, global product specialist for ERI Scientific Beta, says there is complete transparency with a smart beta index.

“Investors have more clarity than with a traditional active product, but construction of the index requires a deeper understanding of financial markets”, he explains.

Ben Seager-Scott, ‎director, investment strategy at Tilney Bestinvest, says: “In simple terms, by having additional rules, smart beta funds can be more complicated.

“It is really important investors take the time to understand what they are buying, how smart beta works, and what the consequences of action could be in different market conditions.

“Due diligence certainly takes longer than it does for a plain vanilla funds such as a FTSE 100 tracker.”

Yet Bill Vasilieff, chief executive for Novia Financial, believes “Smart beta is not more complicated to understand - once explained clearly”. For him, it is all about educating the end investor about the product.

Bryon Lake, head of Invesco PowerShares, agrees: “With the right education and support, investors of all levels can understand smart beta strategies.”

Expenses

This additional complication does come with an additional level of expense, compared with the average cost on a tracker fund.

For example, Martin Weithofer, head of strategic beta at Deutsche Asset Management, said ETFs on major equity benchmark indices such as the FTSE 100 have an average annual management charge (AMC) of less than 0.1 per cent.

“Strategic beta tends to cost a bit more”, he says. “Our equity factor ETFs on value, momentum, low beta and quality all have inclusive fees of 0.25 per cent.”

Smart beta is not more complicated to understand - once explained clearly Bill Vasilieff

There seem to be several reasons behind the higher costs.

Vivian Tung, vice-president, BBH Exchange Traded Fund Services, says: “Smart beta typically requires a customised index, so it tends to be more expensive than traditional index-based products.

However, Ms Tung adds: “Some may argue higher costs are offset by the opportunity to gain alpha.”

Mr Seager-Scott says the reason funds typically trade at a premium to traditional trackers. He says this is caused by two factors - the first being a lack of competition, which allows providers to charge a little more.

He explains: “Since they are new, they tend to be smaller, so fixed costs, as a proportion of the fund size overall, are greater, adding to the relative cost.”

Furthermore, as Mr Weithofer explains: “You have to think about what the investor is getting by paying slightly more for a strategic beta investment, compared with a cap-weighted investment on a major equity index.

“Better control of risk, targeting income, or whatever the aim is - the investor may be willing to pay slightly more to target the strategy that is best for them.”

Also, compared with traditional actively managed funds and portfolios of funds, smart beta strategies can be cheaper. With the introduction post the Retail Distribution Review of clean fund charges, most actively managed funds in the UK come with 0.75 per cent AMCs.

Actively managed funds also need to be rebalanced, incurring trading costs throughout the year, which will be on top of the 0.75 per cent AMC.

Smart beta does have trading costs, due to such products having higher turnover as a result of rebalancing. There will also be bid-offer spreads, which on smaller and newer ETFs will also tend to be wider, but as Mr Seager-Scott says, this will still be lower than actively managed funds.

A study published in March by consultancy Willis Towers Watson, Diversified Growth Fund (DGF) Investing: Is There a Better Way?, posited the argument traditional diversified growth funds are often too expensive, carrying high management and rebalancing charges.

Therefore, using smart beta within a DGF could lower the overall charges associated with active management.

The study said: “The next step for investors looking for higher returns (and with the scope to devote time understanding the risks that come with higher returns) should be to look at DGFs that enhance their portfolios with high-quality alternative smart betas, which can provide extra diversity in the return drivers at a low cost.”