In our last lesson we looked at the most common ETFs available to investors, known as Active or Passive ETFs, these are ETFs that track an market capitalisation based index, and generally have the lowest fees associated with them. If ETFs were icecream flavours, index ETFs are vanilla, but what if plain old vanilla icecream is a bit boring, and you want to add a bit more flavour with some chocolate topping? This is where Smart Beta ETFs come in.
After completing our last lesson, you are probably all excited about getting stuck into some index ETFs. After all 75% of the ETF market is made up of index ETFs and they are the cheapest! Well there can be some disadvantages of index ETFs, some of which are listed below:
All of the above have been used by the active management industry for many years as reasons to use active managers, however the ETF industry has developed a kind of hybrid between active and passive, which has been labelled ‘Smart’ or ‘Strategic’ Beta.
As we discussed last lesson, ETFs track an index. For a passive ETF, the index is market capitalisation based. The difference in Smart Beta ETFs is they are built on alternate indexes to these regular market capitalisation indexes. These alternate indexes can be quite simple, or extremely complex. In their simplest form they may simply weight all companies in an index equally, rather than by market capitalisation. In its most complex form, it may include certain financial factors, or qualities deemed relevant by the index provider. What is important to remember is that whilst Smart Beta ETFs may follow an index, they may rely on a team of investment analysts to create the rules to determine which companies land in the index. Because of this they are a bit of a hybrid between passive and actively managed.
What are some of the Smart Beta strategies out there?
Equal Weight ETFs are Smart Beta in their simplest form, where the index constituents are equally weighted, rather than market capitalisation weighted. This means an equal weight ETF that focuses on the S&P/ASX 200 will have a 0.5% weighting to the smallest and largest company in the index. The advantage of equal weight ETFs is that they can help avoid concentration risk that exists in certain markets.
There’s a thousand and one different financial factors that analysts like to report on when analysing companies. This can include dividend yield, value companies, high growth and quality factors. Index manufacturers can use these factors to build their Smart Beta indexes. For example, an Australian high dividend yield ETF would invest in a bunch of Australian companies with the highest dividend yield.
There’s certain market themes or sectors that may be difficult to identify. An index provider will create a set of rules and nominate companies that meet those themes or sectors. For example, an index that focuses on batteries and battery technology will look for companies that include this as part of their business, set rules for how much of their business needs to be involved in batteries to be included, and create an index around these companies.
Smart Beta indexes can be built around certain values or beliefs. The most common of which in Australia is ethical or ‘ESG’ (Environmental, Social and Governance) principles. In these cases companies will only be able to be included in the constituents if they meet certain ethical criteria. This may involve including only companies that pass certain ethical hurdles, called a positive screener, or excluding companies that fail ethical criteria, called a negative screener.
Whilst Smart Beta ETFs are generally higher cost than passive ETFs, but can allow investors to access markets and themes that passive ETFs simply cannot. They may suit investors looking to avoid perceived failures in market capital weighted indexes, for example equal weight ETFs avoid single sector concentration in highly concentrated markets such as Australia. They also might suit investors looking for certain investment objectives, such as investors looking for high yield. They can also help investors invest in sectors they are passionate about or believe will outperform or even simply to allow investors to invest in line with their values and beliefs.
About 25% of the ETFs that trade on the ASX are smart beta and they account for around 15% of ETFs by size.
Whilst Smart Beta ETFs can offer investors a broader range of investment strategies than passive ETFs, they are still rules based. In a world where history doesn’t necessary repeat, they carry their own risks, by blindly following the rules set by the index provider. There’s a third ETF type that’s been developed, where the fund manager has total control. In our next lesson we’ll take a look at ‘Active ETFs’.