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Getting smart about beta

ETF Watch - Dec 10, 2015

Most market indexes are based purely on weightings by market capitalisation.  This means larger funds by market cap make up a higher weighting of the index. Most ETFs follow these market cap indexes.  A search of the ETF Watch fund database shows by Management type: “Index Tracking” shows 90 of 128 ETFs on the ASX follow this approach. There are some potential shortcomings of market weighted indexes, including:

  • The investor is buying more of overvalued companies and less of undervalued companies.
  • If the index has a large variation in market caps, the investor may be mostly exposed to just a few companies.

The second point is a particular issue in Australia, where as Forager reports, the big four banks, BHP & Telstra make up 42% of the S&P/ASX 200 index. According to a report by the AFR in November, falls in ANZ, BHP, CBA, NAB, Woolworths & Telstra accounted for the 317 points or 6% fall in the ASX for the year up until November 10 2015. Of course in the times where miners and banks were rising, this helped pull the whole index up and investors in the index generally did well.

Smart or Strategic Beta allocations help to overcome these issues of traditional benchmarks. The Australian ETF market now has 21 funds that ETF Watch has defined as Smart Beta in nature. There have been 6 new entrants in 2015 alone.

What is Smart Beta?

Smart Beta (also known as Strategic Beta) are indexes that are created using alternative index construction rules to traditional market capitalisation based indices. They are rules based, so that other than possibly creating the methodology for the index, the manager does not use discretion to choose which companies to invest in. An example may be an index that invests in equal weightings across the S&P/ASX 200 index, overcoming the issue with the second point above.

It is important to note that ETF Watch has only defined funds with the above attributes as Smart Beta. If an ETF is based on an index that has been for example created by the fund’s equity research team based on the stocks they think represent value, we’ve classed this as “Actively Managed”.

The Smart Beta strategies in the ASX

Of the 21 Smart Beta funds on the ASX, they can be split across 4 broad types:

Strategy Type* Details Funds on ASX Tickers
Equal weight index Where the index invests as an equal weighting across all underlying stocks regardless of their size 1 MVW
Fundamental index Where the index has been built on certain fundamentals of the companies, for example, dividend yield, return on equity, company debt ratios 15 AUST, IHD, MVS, QMIX, QOZ, QUAL, QUS, RBSRIG, SYI, UMAX, VHY, WDIV, YMAX, ZYAU, ZYUS
Leverage or Risk based index Where the index takes a traditional index and adds gearing or buys/sells based on rises and falls in the market 2 GEAR, GGUS
Inverse index Not classed as Smart Beta by us (we specifically call these 'Inverse Index' in the management type), but these are funds that follow a traditional index inversely 3 BBOZ, BBUS, BEAR

*It’s important to note that ETF Watch may have a different definition of Smart Beta than others.

How the Australian market currently looks

In Australia, there is an obsession with yield, most likely because of our generous dividend franking rebates and growing numbers of Self Managed Super Funds (SMSFs) requiring income to pay their pensions. Unsurprisingly the biggest focus for Smart Beta locally has been high dividend yield, with 9 Smart Beta Funds counted focusing on yield. 

In the US, Invesco research shows that dividend yield is also the most popular Smart Beta strategy, with also high usage of low volatility and equal weight ETFs. Their research showed that in 2014 13% of institutional flows were to Smart Beta ETFs, up from 7% in 2013. 

The Wall Street Journal states there are now a mammoth 445 Smart Beta ETFs available in the US, this represents 32% of all ETFs, significantly more than the 16% available in Australia. The trends in the US are also showing growing sophistication and complexity in the Smart Beta indexes being created.

What next?

There’s only so many ways other than price a traditional index tracking ETF can differentiate itself, as a result we see Smart Beta as a way for new entrants to genuinely create a niche for themselves. We think 2016 will see continued growth in the Smart Beta Segment. The offerings will also become more sophisticated and the lines between Smart Beta and Active Management will continue to be blurred. Whether these Smart Beta strategies generate additional returns over the traditional index ETFs remains to be seen.

We'll take a look at some of the specific Smart Beta strategies in later posts.

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