ETFs - Spring 2017  

ETFs and the smart beta story

  • Learn how smart beta was established and adopted by retail investors.
  • Understand how to apply smart beta products in an investment portfolio.
  • Grasp whether smart beta outperforms actively and passively managed products.
ETFs and the smart beta story

Smart beta may not be a term familiar to all investors but much of the theory behind smart beta investing has been around for many years.

Definitions of smart beta can vary from provider to provider which has added to investor confusion but generally smart beta products sit somewhere between active and passive.

To understand where smart beta came from and how it has evolved, Martin Weithofer, head of strategic beta at Deutsche Asset Management, takes advisers and investors back to the very beginning of asset management.

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“If you think about the asset management industry and how it’s changed, it used to be the whole of the industry was comprised of funds run by professional portfolio managers who would take a fee for providing their investment expertise,” he explains. 

“But then passive asset management became established, starting in the 1970s but really coming into its own over the last 20 years.

"Over the years passive asset management, which focuses on efficiently providing the market return instead of trying to beat the market, has gradually become a bigger component of the fund management market overall.”

Wider take-up of passively managed vehicles has been spurred on by the ever lower fees and charges offered by passive providers.

Mr Weithofer continues: “But then as passive asset management became more mainstream, providers of passive products began to think about potentially different ways to construct indexes to provide the passive returns.”

Uncovering factor investing

The majority of indices weight exposure to companies by market capitalisation, he observes, which means the bigger companies by market cap get a bigger weighting in the index. This is true of the FTSE 100 index, for example.

He adds, looking at different weighting methodologies can produce some useful risk and return constructs that can help meet different investors’ needs, which is where smart beta comes in.

Darius McDermott, managing director at Chelsea Financial Services suggests the traditional market-cap weighted way of investing in an index has a few obvious disadvantages for investors.

“The largest companies have a disproportionate impact on performance, you invest in good and bad stocks and you are generally overweight overvalued stocks and underweight undervalued stocks,” he notes. “Smart beta came about when people thought ETFs could do better than this.”

Alexander Davey, senior product specialist, alternative beta strategies at HSBC Global Asset Management, points out: “You’ve had a number of academic ideas which have been gradually building over a period of time.” 

“The one that is clearly important for indexing is the efficient market hypothesis, which says all information is known by all participants in the market, therefore it is not possible to outperform the market,” he says.

“And an active manager says, ‘No that’s not the case, I can have an edge because I can have access to information via company interviews, lack of coverage of reports… that enables me to outperform’.”