In life, often the simple desire to invest to grow your wealth becomes bogged down in unnecessary complexity. There are many “expert opinions” and lots of terminology and acronyms which all have the potential to create confusion and investor apathy.
One of the latest phrases being used is “Smart Beta.” Generally, whenever the phrase is used, I see investors’ defences come up as such expressions cause concern and possibly offence. Is it too smart and therefore a risk? Was what I was doing before not smart and are you implying I’m stupid?
The reality is that “Smart Beta” is a somewhat annoying phrase for a part of investing that allows investors a significant amount of opportunity, most of which is very simple. Smart Beta has been around for decades, though most people simply didn’t know it as that. The key point of this article is that, if you can look past the name, you may realise you’ve been a “smart” investor for years and that the concepts are actually very simple.
What Is Smart Beta?
In investment theory there are two “return” concepts known as alpha and beta. Beta simply is the return of the overall market. Taking the ASX 200 as an example, if the ‘market’ moves up by 2% over the year any other investment that also moves up by 2% is said to have a beta of 1. To match the market return, all you need to do is invest in all of the companies making up the market in proportion to their size.
Alpha refers to the ability to outperform the market. Using the example above, if the ASX 200 return is 2% over the year and an investor using that market as their benchmark has a return of 3%, then the “alpha” generated is 1%.
Moving this to everyday investing, these concepts boil down to two philosophies; do you want to attempt to outperform the market, which generally requires taking a higher level of risk or cost to achieve but can be very rewarding if successful? Or are you happy to track the market, where you won’t outperform but you’ll generally keep portfolio costs lower and take less risk?
Both these concepts are relatively well known and have driven the whole active/passive debate. So what is Smart Beta and where does it fit into the picture?
The best way to consider Smart Beta is as an alternative way of selecting or weighting the companies in your portfolio that isn’t just based on their size. The very best example of this is dividend yield. There are many indices and funds that track companies with a historic record of paying higher dividends than the general market. You probably never thought of this as Smart Beta but it is. The choice to make ‘yield’ the primary target of your selection, versus size, has put you on an alternative course which will give a return profile different to the standard market return.
So what other types of alternative weightings are there? The answer is that there are many, but only really a few that have become mainstream assets classes in their own right. These include yield, volatility, equally weighted and fundamentally weighted. These four Smart Beta strategies form the basis of the majority of strategies that investors use to produce returns over and above the market. Each has their own philosophy, for example, equal weight is premised on under-investing in large capitalisation companies and over-investing in smaller companies, with the view that small cap companies are likely to outperform over certain periods.
Is it here to stay?
Smart Beta is definitely here to stay.
First, it was here already (see point on dividends).
Secondly, there’s no basis to the view that measuring a market by size is the best way. Yes it’s the traditional way, but not necessarily the best.
Thirdly, many active managers have been using such strategies for years, whilst calling them active and charging active fees. Such active managers are commonly termed “index huggers” as they are just using a set of basic rules to try to beat the market versus a sophisticated assessment of each company’s fortunes, or some other unique strategy that cannot be replicated.
Finally as the global investment community gets more sophisticated, they are requiring tools to achieve different outcomes – higher yield, lower volatility, better small cap exposure etc.
Summary
Ultimately, once investors get over the name, Smart Beta gives a much wider opportunity set than just market size. With developed world interest rates so low, investors need all the tools they can get to heighten their chance to build their returns.
To find out more about ANZ ETFS’ range of ETF products, including our Smart Beta options, visit www.anzetfs.com.
