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Helping to bridge active-passive gap

This article is part of
Passive Investing – May 2016

Helping to bridge active-passive gap

The term ‘smart beta’ often raises questions among investors – the most common generally being, ‘what is it?’

It is an important question as different providers have different definitions, investors need to know what it is they’re investing in, and smart beta strategies differ from other passive strategies that simply track an index like the FTSE 100.

Simon Midgen, head of index strategy at Legal & General Investment Management (LGIM), admits the term has stuck even though it is “somewhat confusing”.

“Confusing because it suggests regular index management might be dumb beta, which is certainly not the case,” he says.

“Smart beta is probably anything that is not market-cap driven, so anything other than a strategy that is benchmarked against a standard market index, the FTSE All-Share, for example. Standard market indices are built where the calculation of the index gives more weight to bigger companies and less weight to smaller companies in proportion to their size – pretty straightforward.

“Smart beta is anything that deviates from that, so has a different calculation methodology or weighting approach.”

The rise of smart beta

Howie Li, head of Canvas at ETF Securities, comments on where smart beta strategies sit within an investor’s portfolio:

“What we’re seeing in the market are lower cost products for investors, which can only be a good thing. Smart beta gives investors the ability to generate something on top of market cap returns but it requires an understanding of how these tools should be used.

“There will always be active managers that can deliver additional returns but investors must do their due diligence and check that the investment process can deliver and has delivered value so that the additional fees are justified. Market-cap investing also has a place if investors simply want market exposure.

“Therefore, the merits of an active, passive or smart beta strategy within a specific portfolio must be carefully weighted by advisers with clear grounds for choosing one over another. It is likely that a portfolio will have a blend of each, and each strategy will continue to have a place in an intelligently diversified portfolio that delivers their clients the best value.”

Chris Mellor, executive director, equities product management at Source, offers a similar explanation: “There is a lot of divergent opinion. Our definition is pretty broad, it’s basically anything that deviates from a simple market cap weighted benchmark and does so in a systematic, rather than a discretionary, way.”

In the past, smart beta strategies have been more commonly used by institutional investors but passive providers are increasingly bringing to market smart beta products aimed at retail investors.

Mr Midgen observes he has seen a significant amount of assets flow into smart beta strategies, although this is still dwarfed by the assets held in traditional index-tracking funds. By December 31 2015, LGIM had £25bn in smart beta strategies and £298bn in index strategies.