The debate between active and passive investing always tends to rear its head in times of equity market volatility, as we have experienced thus far in 2018. It does not always have to be so binary – investors can use passive products such as exchange traded funds (ETFs) to get very specific market exposure. These more specialist ETFs are known as 'smart beta' and allow investors to get the benefits of cheap passive fund construction, but do not simply build a portfolio by weighting to stocks based on their size. Smart beta funds can weight to stocks based on algorithms, or rules, like which companies exhibit the most of a market factor such as value, growth potential, volatility, momentum or income. They can also provide passive exposure to a specific sector or theme.
Smart beta strategies hit their stride in 2018. In a year when active funds struggled to find buyers, smart beta funds continued to attract assets. There were new and increasingly innovative fund launches, with ETFs focusing on new technology areas such as robotics and artificial intelligence (AI), and a growing focus on strategies to do good. iShares launched its Sustainable Core range – six ETFs focused on companies with good environmental, social and governance (ESG) records –while Lyxor launched the Global Gender Equality UCITS ETF (GEND). The smart beta space continued to challenge actively managed funds, adding weight to the idea that carefully honed fund management skills can be replaced by an algorithm.
Looking at which smart beta funds did well, it was an interesting and slightly mixed year for those focused on manipulating market factors. ETFs that track indices that minimise market volatility or market drawdowns did well; the MSCI World Minimum Volatility index outperformed the MSCI World index, with the same split witnessed in the MSCI United Kingdom index and MSCI indices covering Europe, Japan and emerging markets.
Bruno Taillardat, head of smart beta at asset management company Amundi, says: “Everything that succeeded before the summer proved more difficult afterwards. Over the past two months, minimum volatility, risk parity and drawdown-minimising funds – anything focused on risk reduction – came to the fore. In the first half of 2018, the market went up sharply, driven largely by US technology stocks.
Smart beta funds tracking market factors such as momentum and quality stocks did better at capturing the growth of the technology stocks in the first part of the year, as did a number of sector-based ETFs. But overall it was the defensive factors that held on.
Factoring in defence
The tough question for investors is what comes next. Smart beta funds can help investors get cheap and easy access to market factors, some of which can help add defence to a portfolio. If market volatility remains elevated, investors may want to pare back their overall stock market exposure, or specifically tilt towards smart beta factor ETFs associated with defensive characteristics such as low volatility or quality.
Going defensive should also mean ensuring avoiding exposure to other, riskier market factors. Mr Taillardat adds: “Momentum strategies tend to struggle at inflection points [when markets are neither on an upward or downward trajectory] because they are based on a trend. Once the market re-establishes a stable direction, they may do well again.”
With minimum-volatility smart beta funds, investors must be able to tolerate missing out on some of the upside in markets; they would in effect experience less of the market highs and less of the lows.
Peter Sleep, a senior portfolio manager at Seven Investment Management, says: “Low-volatility stocks have better risk-adjusted returns than high-volatility stocks. This does not mean they go up more than other stocks, they actually go up less, but when you adjust for volatility performance is better.”
Turning elsewhere, defensive attributes could be found in smart beta ETFs that tilt towards quality stocks. In theory, these should perform in all market conditions because they focus on stocks that have high profitability, strong growth and good balance sheets. However, if valuations get too high, such exposure may not be so appealing.
That value tilt
Valuations leads on to the next potential factor investors could use smart beta funds for. The elephant in the room is the large valuation gap between quality and value stocks. For the past decade, value strategies have struggled – but this was up until a few months ago. Investors may have finally appreciated how much they were paying for the growth in technology stocks.
However, it would be optimistic to predict a resurgence for this type of strategy after just two months. Mr Sleep says: “I personally think that value stocks look attractive, although I have believed this for some time and I have been consistently wrong.”
There is academic evidence suggesting value stocks should do well when the valuation gap with growth companies is historically wide. Mr Sleep says: “Value is one of the most powerful smart beta strategies through time. Professor Elroy Dimson’s work shows that £1 invested in the value factor in 1955 would have been worth £9,173 by the end of 2016, or a return of 16 per cent a year, whereas £1 invested in growth stocks would return 10.3 per year.
"This does not mean value outperforms all the time. The past 10 years has been bad for value stocks and they have underperformed significantly. Value investing has experienced long periods of underperformance in the past only to come roaring back later."
Finding one specific market factor to help protect your portfolio can be difficult. Those who do not want to make this thorny decision can turn to smart beta funds that incorporate multiple market factors but do not revert to relying on the market cap of stocks to decide which stocks to weight towards. This style of investing is growing in popularity, as are the number of ETFs that offer it. However, investors must ensure they understand which market factors they will be exposed to.
Andrew Walsh, head of passive and ETF specialist sales UK and Ireland at UBS, says: “A multi-factor strategy diversifies across multiple single factors. This can also improve a portfolio's risk-adjusted returns, while providing broader market exposure versus a single factor approach."
Smart themes
Matt Brennan, head of passive portfolios at AJ Bell, says he thinks two smart beta areas will become more popular next year. The first is thematic investing in areas such as healthcare, cyber security and the ageing population: “Traditionally, thematic investing has been an area for active managers, as it takes time to identify companies linked to certain themes. However, with the advent of ‘big data’ this can now be done in a rules-based way such as in smart beta ETFs."
He also believes that some of the income products have become more nuanced and a stronger proposition for investors: “Previously, passive income investing meant buying the largest yielding stocks, ranked by largest yield. This is flawed as it pushes investors into at-risk sectors such as energy and banking, and into certain regions such as the UK and Europe. As such, traditionally, investors have stuck to active income investing to ensure any income generated is sustainable. However again over the past few years passive fund and smart beta providers have managed to improve the rules of the income products, to make sure the income is sustainable.”
Do the algorithms on which these strategies are built stand up in more difficult, less liquid conditions? The early signs are positive
The concept of smart beta still has its detractors, with concerns around entrusting capital to an algorithm at a time when markets are volatile. Mark Leach, portfolio manager at James Hambro and Partners, says: “I am concerned that there is no incentive to understand the underlying value of the company, to do sensible forecasting, to look at a company’s returns or cost of capital. We have started to see pockets of risk occur.”
However, Mr Sleep believes this is more a problem associated with normal passive funds than smart beta. This year, smart beta funds showed they can do many of the things an active manager can do, yet cheaper. More volatile markets will prove a test. Do the algorithms on which these strategies are built stand up in more difficult, less liquid conditions? The early signs are positive.
