InvestmentsSep 3 2015

The smart beta boom

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■ 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.

It is not surprising that dividends are by far the largest category of smart beta ETFs given that a) many investors buy

certain stocks or funds because they are after the income, and b) in today’s low-yield world – in which fixed income would traditionally pay returns of 5 per cent a year but now pay at little over 0 per cent – investors now have to source yield and income from other asset classes such as equities.

Smart beta indices incorporate a passive rules-based discipline to rebalance exposures to a fundamental metric of value. The rules and methodology will generally cover:

1) Screening and selection (which stocks to pick).

2) Weighting (how to weight the individual stocks chosen).

3) Rebalancing (when to reshuffle, that is, re-screen and re-weight the basket).

We will now look at how a smart beta dividend index might work. An index’s initial screening and selection process could use dividend yields as a metric to filter the highest yielding stocks from the universe. It may next choose to weight the basket of highest dividend yielding stocks by the dividends paid over the last 12 months to minimise potential value traps. The annual rebalance methodology then adds or deletes stocks to ensure the constituent stocks consistently meet the index criteria.

The potential advantages of smart beta ETFs therefore include:

■ enhanced portfolio returns for a given level of risk;

■ reduced portfolio risk for a given level of return;

■ increased dividend income (in the case of dividend ETFs); and

■ the benefit from more complete diversification, since only buying funds based on market cap indices may not be optimal.

Why does smart beta work with ETFs?

■ Smart beta ETFs in Europe are set to remain on their current growth trend as the investors fully appreciate both the potential benefits of smart beta and the efficiency of an ETF.

■ ETFs are extremely liquid. ETFs are as liquid as the underlying market, since extra units can be issued according to demand. Additionally, being listed on an exchange, ETFs can be traded throughout the day. Many comparable funds may only trade at the end of the day, week, month or quarter.

■ The minimum investment is low. Investors can trade as little as one ETF share which could cost as little as £5 or £10 a share. Most traditional, non-ETF alternative strategies have minimum investment requirements that can be prohibitive.