Due diligence conundrum over smart beta fund labels

Due diligence conundrum over smart beta fund labels
 Same factor, different performance

Factor-based strategies with ostensibly similar approaches have left investors with materially different risk-return profiles, specialists have warned, as they urge fund buyers to boost their due diligence.

The rise of a new type of passive investing has seen fund houses offer a growing number of factor-based – or smart beta – strategies, which theoretically capture specific exposure more efficiently than traditional trackers and at a lower cost than active funds.

Such products – which typically take the form of exchange-traded funds (ETFs) – can follow a variety of different indices despite in theory tracking the same investment style, causing a headache for fund selectors.

Even at a basic performance level, products following the value factor that gained momentum last year differ materially depending on which index they track. Data from FE Analytics shows the FTSE World Value index outstripped its MSCI World Value counterpart by 33 percentage points on a 10-year basis.

Hortense Bioy, director of passive fund research in Europe at Morningstar, said the discrepancies meant the onus was on fund buyers to step up their due diligence. She claimed they had now been left with “a big educational burden”. 

Morningstar research found that US equity ETFs focusing on value names “vary significantly in their construction methodologies”, leading to completely different risk-return profiles.

“When it comes to factors, it’s important that investors understand the economic theory behind them. Does it make sense?” Ms Bioy said.

The latest development in the smart beta space came last week when Fidelity launched two income-focused ETFs. The asset manager’s products will track Fidelity-branded indices to offer a “truly differentiated” product. 

However, variance in index construction could mean significant differences in returns.

Fund buyers already have to contend with disparities in the traditional passive space. The FTSE All-World index, for example, has much higher exposure to emerging markets than its MSCI World counterpart. Even investors in the traditional passive market have a limited awareness of these issues, according to Square Mile head of research Victoria Hasler.

“It’s something that a lot of people don’t really think about. They don’t necessarily appreciate that there are differences in indices,” Ms Hasler said.

While Square Mile does not cover the smart beta universe, its research on passives focuses on underlying indices. But Ms Hasler said other priorities, such as product fees, interfere with such due diligence. 

Fund buyers including Sophie Muller, head of research at EQ Investors, said due diligence on traditional index funds should be a matter of course. However, Ms Bioy warned transferring traditional passive approaches to smart beta funds was difficult.

The matter is complicated even further by a lack of consistency on definitions among fund buyers and managers on what factors mean and how they should be approached.

Ms Bioy said: “Investors have to understand the index construction methodology. They have to understand why a provider [might] decide to limit a universe to 100 stocks or 200 stocks. You just accept that.”