The smart beta boom

It is common today to hear the phrase ‘smart beta’ discussed alongside ETFs at industry conferences or in the financial press.

This is not surprising given there are approximately 200 smart beta ETFs listed in Europe. The total assets under management in these European ETFs exceed US$31bn (£19.9bn) as at 15 July this year, having increased by US$8.6bn (£5.5bn), or 38 per cent, since the start of last year. Most of these assets – in fact 93 per cent of AUM – are equity-based ETFs.

Most ETFs track market capitalisation-weighted indices which weigh individual components by their market capitalisation. This must be based on the belief that weighting stocks by market cap gives the highest return for a given level of risk.

Article continues after advert

However, this belief is now being challenged. An analysis of performance demonstrates that market capitalisation weighting may not always be the best method of indexing. In fact, according to Cass Consulting, a research-led consultancy service provided by Cass Business School, returns of traditional, market capitalisation-weighted incices are lagging behind alternative – or smart beta – indices by as much as 2 per cent a year from 1969 to 2011.

So from my perspective, the difference between ‘beta’ and ‘smart beta’ may be the idea that smart beta seeks to provide an exposure with the potential to outperform the market, isolate or accentuate a certain characteristic of the market, or generate better risk-adjusted returns than the market, rather than merely measure the performance of all investable stocks in an equity market.

How are ETFs using smart beta to get better returns? Over 200 ETFs exist today in Europe which track smart beta indices. These smart beta indices generally fall into the following categories:

Fundamentally weighted indices:

Components are selected to provide broad exposure to an equity market, but companies are weighted by fundamental factors such as aggregate dividends or earnings, price-to-book ratio or free cashflow.

Equal weight indices:

Components are often selected from established incices such as the S&P 500, but are equally weighted so that all components have identical weights when rebalanced.

Factor-based indices:

Components are selected based on one or more fundamental factors that define risk, return and correlation, and span more than one asset class.

Low volatility indices:

Components are selected because they have exhibited lower volatility than the overall stock market and/or are weighted based on their historic volatility.

Of the US$29.3bn (£18.8bn) in smart beta equity ETFs listed in Europe:

■ the two largest groups are dividends with US$17.5bn (£11.2bn) or 60 per cent of AUM, followed by low volatility with US$4.1bn (£2.62bn) (or 14 per cent) of the AUM; and

■ the two largest regions are European large cap with US$6.7bn (£4.3bn) [23 per cent] of AUM and Global large cap with US$5.8bn (£3.7bn) [20 per cent] of the AUM, with US large cap and real estate equity closely behind at more than US$5bn (£3.2bn) each.