Be a Smart Index Beater: track it with a Smart Beta!

26 Sep
Money Tree

A Passive ‘Smart Beta’ Fund acts a bit like a money tree – except with less watering required.



‘Smart beta’ funds, trackers with rules like ‘minimum volatility’ giving an ostensibly advantageous slant to the way they follow the securities in an index, have become a core part of many portfolios. Russell Investments’ survey in January 2014 found, of a sample of equity investment managers at around 200 asset owners in Europe and the Middle East, and North America, 32% have smart beta holdings. Of the average cross-region allocation, 40% of participants in Europe use smart beta (vs 24% in North America).

The weight of smart beta allocations is highest among the biggest asset owners. What’s more, most testified to their intention to evaluate the value added from smart beta within the following 18 months: 88% of survey participants with over $10billion in AUM, and for smaller funds of AUM between $1billion and $10billion, a healthy 77%. So the strategy is one being considered by the majority of the investor population.

Minimise Risk and Downside, Without Constantly Calculating Asset Correlation

There are numerous ‘smart’ beta methods to organising the assets in a fund. One of the most popular is low, or minimum volatility which selects the stocks with the lowest variance in a given index. Another tactic for minimising risk is equal risk weighting, where all constituents of the base index are weighted by their risk volatility contribution.

An example is the Compass EMP US 500 Enhanced Volatility Weighted Index ETF, a relative market newcomer which only arrived in July 2014. It tracks the CEMP US Large Cap 500 Long/Cash Volatility Weighted Index before expenses. The index takes the 500 largest US stocks by market capitalisation, after screening them to ensure four consecutive quarters of positive returns. All the 500 stocks are weighted according to their daily standard deviation (volatility) over the preceding 180 days compared to the universe average. The asset allocations are re-evaluated and adjusted every March and September.

The ‘enhanced’ factor of this particular fund, which justifies its slightly elevated expense ratio of 0.68%, is the built-in downside protection in its organisational structure. If the month-end price of the CEMP US Large Cap 500 Long/Cash Volatility Weighted Index has fallen 10% or more below its highest daily value (DHV), the ETF will liquidate 75% of its holdings. If the Index recovers 10% or more, all the securities would be reinvested.

But there are further conditions which guarantee re-entry on favourable terms to the ETF’s clients: if the Index declines 20% from its DHV, 25% will be reinvested back into the fund; a further 25% once the Index falls 30% from its DHV; and a final 25% if it drops below 40% of its DHV. After the equity market bottoms out, the fund would ride the curve up towards recovery. Not for nothing did it make’s ‘top ten’.

Min-volatility funds can be used as an alternative benchmark to the index itself for those with a more cautious investment strategy; the ploy has occasionally been used as a proxy for an active hedging strategy. Minimum variance allocations are more useful in market downturns, where they minimize downside, than expansive markets. They are also a safer way to gain exposure to asset classes perceived as a greater risk, like some emerging market, small-cap or high-yield bond indexes.


Why Weight Allocations by Market Cap? You’d do Better to Ignore Investor Sentiment

Then you have your alternative takes on capitalisation; many smart beta ETFs choose to do this through weighting stock allocations by fundamentals rather than market capitalisation. There are two competing products worth noting which use the Research Affiliates Fundamental Index (RAFI) methodology.

The Fundamental range by asset managers Charles Schwabb was launched last August 2013. The six new ETFs were based on a weighting methodology for market capitalisation using metrics like five-year average sales, five-year average cash flow, book value, and five-year average dividends. The pre-established PowerShares ETFs were also crafted around the Research Affiliates Fundamental Index (RAFI) methodology.

Research Affiliates describe the major selling point of their pioneering method: “Fundamental Index strategies have a value tilt and a slight small-cap tilt. These tilts, however, are dynamic: when value stocks are out of favour and thus are cheap, Fundamental Index strategies tend to increase their allocation to deep value stocks… When value is in favour, the value tilt is much milder because these stocks tend to be priced higher. Rebalancing into unloved stocks and out of the most popular stocks – which we call ‘contra-trading’ – provides the majority of RAFI strategies’ added value.”

A randomly selected example from Charles Schwabb’s six-suite ETF that would be expected to deliver solid performance is the Schwabb Fundamental International Large Company Index Fund. The FILCXF delivered total returns of 3.88% YTD for the periods ending 08/31/14. This is actually less than the Russell Fundamental Developed ex-US Large Company Index, which delivered 4.34% returns over the same period.

The index ranks companies in the Russell Dev ex-US Index (excluding the US), by fundamental measures of size, and then tracks the performance of all those companies whose fundamental scores (size, cash flows, book value and dividends) are in the top 87.5% of the Russell Dev. The index uses a partial quarterly reconstitution methodology in which the index is split into four equal segments at the annual reconstitution and each segment is then rebalanced on a rolling quarterly basis. Its bias towards the higher-valued stocks probably explains its superior performance; Charles Schwabb admits its methodology entails a time-lag while the under-valued mid-cap stocks it picks up at a discount start to appreciate to what should be their market value, according to their fundamentals.

An Option for the Dividend Investor

The final strategy to cover, and one almost guaranteed to provide a constant income, is dividend investing. It’s not complicated, but it works. Morningstar rates investment platform Hargreaves Lansdowne’s tax-efficient ISA smart beta funds fairly highly. It gave three stars to the iShares FTSE UK Dividend Plus product, which has a dividend yield of 4.16%, and provides quarterly payouts. This year the fund has grown just 1.44% in value, compared to its two-year performance of 20.2%. Nevertheless, Morningstar analyst Hortense Bioy calls it “a suitable tool to implement different strategies… This broadly diversified, large and mid cap-focused fund could easily serve as an alternative core UK equity holding for investors seeking a regular income stream. It could also be considered as a satellite holding,” rather than a major holding, as ISA accounts for 2014/5 are capped at £15,000.


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