Smart beta ETFs: focus on what’s important

Nov 17th, 2015 | By | Category: Equities

Smart beta exchange-traded funds have attracted considerable attention, and assets, in recent years, sparking a great deal of debate. Much of this debate has been centred on the term itself, “smart beta”. Some argue that it implies market capitalisation-weighted ETFs are therefore “dumb beta” and that this inference can be misleading for investors. While the term smart beta may be open to misinterpretation, it has undeniably become part of the financial lexicon and, semantics aside, is now the most widely adopted term to describe rules-based non market cap-weighted and strategy-based investing. So let’s all move on from discussions over the term itself and, instead, focus on what’s important.

What is smart about smart beta ETFs?

Smart beta ETFs have garnered assets and much debate in the investment community.

When it comes to investing in smart beta ETFs, investors must be aware that while the implementation of these portfolios follows a systematic process similar to passive index investing, these funds take an active bet on the outperformance of factors such as value, small cap and momentum. As such, investors need to be confident in the research that underlies these strategies and their implementation within an ETF.

“It is imperative that ETF issuers and index providers are judicious in the design and creation of smart beta ETFs,” said James Waterworth, Vice President, UK & Ireland Institutional ETF sales at Lyxor, leading provider of smart beta ETFs.

He added: “The smart beta strategies that underlie Lyxor’s product suite are often based on several decades of rigorous academic research and further refined to ensure the hallmarks of an ETF are met, namely liquidity and transparency.

“Some ETFs marketed as smart beta do not meet this threshold, thus investors equally need to be judicious.  Smart beta straddles the space between active and traditional market cap indices, with the fees reflecting this.”

What can be definitely be considered “smart” about these products is that they can offer investors transparent and systematic access to factor exposures which were traditionally only available through active funds which charge, in many cases, in excess of 1% in annual management fees.

“Smart beta ETF fees are generally higher than standard market cap and much lower versus active funds providing access to the same risk premia,” said Waterworth. “This is primarily attributable to three reasons: 1) higher indexing fees, as a legitimate recognition of development costs and intellectual property; 2) research effort and client service, smart beta is a research-intensive business, including the selection of third-party strategies, provision of client guidance and ongoing reporting; 3) higher complexity and the value add of the portfolio manager given the magnitude and frequency of portfolio rebalancing inherent in smart beta strategies.”

The range of smart beta ETFs that have come to market is considerable and possibly overwhelming for new adopters. The best place for investors to start is by considering their goals. For example, investors hoping to time factor outperformance or create long-term portfolios focused on the outperformance of specific factors, can look to a combination single factor ETFs. Lyxor, UBS, iShares and Deutsche AWM offer a range of single factor funds which offer targeted exposure within European and US equities to factors such as low-size, value, quality, low beta and momentum.

A core equity position can be achieved with more diversified ETFs which tilt towards multiple smart beta factors. The PowerShares FTSE RAFI Developed 1000 UCITS ETF (PSRD) and the Lyxor’s JP Morgan Multi-Factor Europe Index UCITS ETF (LYX5 GY) are two examples of these funds.

For an investor looking to de-risk a portfolio, a low-volatility ETF could be the right choice, these are available from many ETF providers including SSGA and Source.

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