Investments  

Is the RDR increasing interest in smart beta strategies?

Passive investing has traditionally been cheaper than active. But an expanding breed of funds look to add something extra to passive investing, without adding on the cost of active management.

What is smart beta?

Conventional market capitalisation weightings for index trackers have been criticised for delivering poorer returns through overweighting overvalued stocks and underweighting undervalued stocks that are more likely to bounce back. Smart beta strategies propose to provide a better risk/return trade-off than traditional market-capitalisation weighted indices.

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In a nutshell, smart beta funds track the market but in a different weighting or structure than the traditional indicies. This requires managers to take a view on what weighting would be preferable, but is still looking to capture the “beta” – market return – rather than the “alpha” return, the element achieved by active management. The strategy is best suited to exchange-traded fund (ETF) format.

The case for enhanced passive

The move to a fee-based model means that reducing clients’ portfolio costs has become more of a priority for advisers post-RDR. This has helped in encouraging investment in passive funds, and for those who want to improve portfolio diversification without getting into actively manage funds, the answer could be smart beta strategies.

JP Morgan has just outlined plans to become the latest provider to enter the booming world of smart beta ETFs. Its strategy plans to screen for certain investment characteristics such as attractive relative valuation, low volatility and specific market capitalisation, but has not disclosed which index it will track or charges. Other existing players in the market include Axa and db X-trackers.

Good or bad?

Billed as the current ‘hot topic’ in ETFs, smart beta ETFs are not without their critics, but they do represent a cheaper way to invest than active funds. It does not involve so much day-to-day decision making for a fund manager, but higher trading costs may apply as smaller, more illiquid stocks are being sought.

The label ‘smart beta’ has been criticised in itself, and product providers are rebranding the strategies with names varying from ‘advanced beta’ to ‘new beta’ to ‘beta plus’. Although critics have accused it of being a fad, there is merit in the basic premise: over time, smaller-cap stocks outperform large-cap stocks, something straightforward index replication does not take into account.

Smart beta strategies are diverse, and not all funds have outperformed market-cap weighted funds. They also generally have higher expense ratios.

While being aware of the criticisms of smart beta strategies as a short-term trend, they could be beneficial for clients who still want the low-cost element of passively managed funds. The market is expanding rapidly, so there will likely be more choice of funds in coming months.