Smart Beta. It sounds like some fancy finance industry buzzword. But if you’re not familiar with the term, and with the funds based on a ‘smart beta strategy’, you will be soon. And you should be.
Smart beta is a marketing term given to a type of exchange traded funds (ETFs). They are the fastest growing class of ETFs.
Let’s go back a bit. Before you consider smart beta funds, make sure you know about standard ETFs. These are simply funds that track an index, like the ASX 200 or the S&P 500. You can buy and sell these ETFs on the stock exchange. They’re designed to be an easy way to buy a diversified portfolio of companies and have low fees.
Because these ETFs hold the same stocks as the indexes they track, and in the same proportion, when the big stocks rise and fall, the ETFs will feel more of an impact than from when smaller stocks move.
Take the ASX 200 Index for example. Movements in Commonwealth Bank [ASX:CBA] determine 9.17% of movement in the index, BHP Billiton [ASX:BHP] 7.2%, and Westpac [ASX:WBC] 7.08%. While the smallest companies in the ASX 200, BC Iron [ASX:BCI] and Medusa Mining [ASX:MML], have much less of an impact, with just 0.01% market weight each.
That’s where smart beta ETFs come in. Instead of copying the index and using company size, or ‘market capitalisation’, to decide what to buy, they do things differently. The fund managers buy more of the companies they expect to do better than average.
Here’s a theoretical example of this in action…
The asset management firm Schroders rebalanced the MSCI World Index and assigned higher weights to companies with longer names.
It’s hard to believe that would add value — what’s the length of a company name got to do with its share price? Yet, looking at its returns (below), the length of a company’s name appears to have a big impact on performance.
Of course, this is not the case. What you’re seeing is the benefit of moving away from a market weighted strategy, to a smart beta strategy. The largest companies — and therefore most widely held and popular companies — have less impact on performance. This means companies that are not yet so widely held, and haven’t been bid up to the same extent, influence the index more. This gives you a better chance of beating ‘the market’ and making more money.
Now, of course, you won’t find ETFs with weightings based on the length of company names — even if it does seem to be an effective strategy. But there are thousands of smart beta ETFs available. Most of these are found in the US and can be traded through an international trading account.
ETFs are still relatively new in Australia, but the market is growing and there are many smart beta options on offer. Smart beta ETFs now make up 10% of Australia’s ETFs.
One of these is the BetaShares FTSE RAFI Australia 200 ETF [ASX:QOZ]. The ETF is designed to track the FTSE RAFI Australia 200 Index, which buys shares based on four fundamental measures. They are revenue, cash flow, book value and dividends.
This approach has shown a superior return over the market if we go back over 20 years. More recently, it outperformed the ASX 200 index by more than 5% in 2013 when dividends are included.
Of course, there’s no guarantee that these smart beta ETFs will beat the market. However, I’m currently looking to add smart beta ETFs to the Albert Park Investors Guild’s portfolios.
The portfolios already hold standard ETFs diversified across property, commodities, bonds, and shares. So far the strategy is working well. The portfolio value has been steadily growing since it began in August. My analysis suggest adding smart beta ETFs will see us continue to beat the market.
Investment Director, Albert Park Investors Guild