Exchange traded funds (ETFs) are associated with passive index tracking, but, as the number of funds grows, providers are increasingly launching what they call 'smart beta' ETFs. Rather than tracking a mainstream index such as the FTSE 100, they track indices constructed to have a special focus or to minimise risk.
Recent additions to this space include iShares ETFs based on minimum volatility indices, which seek to offer reduced volatility compared with standard market-capitalisation-weighted indices. iShares MSCI Europe Minimum Volatility(MVEU), iShares MSCI World Minimum Volatility (MVOL), iShares MSCI Emerging Markets Minimum Volatility (EMMV) and iShares S&P 500 Minimum Volatility Fund (SPMV)are aimed at investors looking for a smoother ride and are the first ETFs domiciled in Europe to be created on these indices.
The MSCI Minimum Volatility indices are constructed by optimising the respective parent MSCI Indices, which are capitalisation-weighted, by determining weights for securities in the indices with the lowest total risk. Index constraints such as country, sector and style exposures are applied to the optimisation to ensure diversification, while broadly matching the profile of the corresponding cap-weighted MSCI index.
"This new suite aims to offer an attractive investment over the longer term with the potential to provide a better trade-off between risk and return, something that simply holding cash does not do," says Stephen Cohen, head of investment strategies and insight at iShares. "Since the onset of the financial crisis, overall equity market volatility has risen both in terms of the magnitude and the frequency of volatile episodes. Between 2007 and 2011, the MSCI Europe Index saw +/- 2 per cent daily moves more than three times a month on average, compared with the previous three years when this only happened approximately five times a year. This heightened volatility over recent years has deterred many investors from accessing equity markets."
The funds have a total expense ratio of between 20 and 40 basis points and physically buy shares in the indices they track rather than getting exposure via a derivative swap.
Other examples of smart-beta ETFs include funds that track bond indices put together on the basis of the country's GDP rather than the bonds issued. The advantage of this is that less indebted countries and companies account for a larger part of the index and highly indebted ones are less prominent. A problem with traditional bond indices is that the largest constituents can be the most indebted countries or companies.
Howard Chan, product manager at fund provider Pimco, says that such an approach can help achieve better global allocation and diversification, and constructing the Pimco Global Advantage Bond Index in this way has decreased volatility.
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Others offer access to more unusual strategies such as the Source Man GLG Europe Plus ETF (MPFE) for which the underlying index composition is not dictated by market capitalisation of its constituents, but by broker recommendations. Read our tip on this
Source also offers what it describes as 'enhanced' commodity ETFs, which try to track spot prices more accurately. Commodity ETFs, which invest in futures contracts rather than the physical commodity, have to sell the futures contracts when they are approaching expiry at a pre-agreed price and buy a new one. But if the price of futures has risen and the ETF pays more for the new one, eating into its returns, it may not do as well as the spot price.
However, funds such as Source Crude Oil Enhanced T-ETC aims to mitigate this when the price of futures is going up by rolling to a longer-term contract which does not have to be renewed as often.
Providers argue that these types of smart-beta ETFs are still different to active funds where a manager tries to outperform rather than track an index. Mr Chan says that if you are tracking, it makes sense to allocate the best way you can, which specially constructed indices aim to do. These also have lower costs than active funds.
Michael Lyttle, managing director of ETF provider Source, adds that these types of ETFs can also offer greater transparency than active funds as they allow you to check what the funds are holding on a daily basis, and as they are listed shares you should be able to sell them quickly if you want to, which may not be as easy with a traditional active fund.
However, Christopher Aldous, chief executive of wealth manager Evercore Pan-Asset, says it is important to look at the methodology of the underlying index and whether it is constructed according to a set of rules rather than a manager taking a subjective view. In the case of the latter, it might not be clear what you are taking on and the more active you get, the more risk of underperformance. He cites optimised ETFs, which buy a sample of holdings in an index rather than every constituent, so effectively involve some active management, and can have wider tracking differences than ones which buy all or nearly all of the constituents in an index.
He also says creating a product that would have worked in past market conditions may not do as well when circumstances change.
