Independent financial advisers (IFAs) are well aware of the active versus passive debate: in pursuit of maximising returns for their clients, should they select lower cost, index tracking funds or higher-charging, actively managed funds?
Until recently, there seemed no third alternative to this. But this situation has changed now with the advent of smart beta1 exchange traded funds (ETFs).
A smart beta ETF will use an automated, rules-based investment process, instead of employing active management via a team of analysts and a portfolio manager, so the fees on these products are lower than active funds.
But smart beta ETFs take a different approach to market-cap-weighted index (i.e. ‘beta’) investing, and many of these strategies aim to outperform the market, just as an actively managed fund would. In a sense, smart beta ETFs may offer the best of both worlds.
The smart beta universe is huge and extremely diverse. In basic terms, it effectively categorises funds that use filters and characteristics other than just market capitalisation to select and weight each of the constituents.
Some of these ETFs will simply aim to isolate a particular part of the market, such as value stocks but they will not have performance as an objective. We would categorise these types of ETFs as ‘tools’ that enable investors to tailor their portfolios to exercise specific tactical views.
Other smart beta ETFs will follow more complex rules and aim to outperform a relevant market-cap-weighted index. We would categorise these types of ETFs as ‘strategies’. As such, they may be suitable to replace or complement core holdings.
From a cost perspective, smart beta ETFs are likely to be more expensive than the ‘plain vanilla’ passive variety but, due to lower turnover at the portfolio level, could potentially be cheaper in the long run.
Although smart beta is a much smaller proportion of the ETF universe compared to the plain vanilla variety, it is currently the fastest growing segment and has attracted growing interest globally, including from IFAs. As such, Citigate Dewe Rogerson (CDR), on behalf of Source, conducted research2 among UK IFAs to assess their thoughts on this exciting and fast-growing segment of the ETF/passive marketplace.
The results revealed a surprisingly high adoption given smart beta’s relatively recent entry to the market. Just over a fifth (21 per cent) of the IFAs surveyed said they currently invest in one or more smart beta strategies and of those that don’t, 19 per cent anticipate they will do so over the next two years.
Moreover, 42 per cent of IFAs believe assets in smart beta funds will grow between now and 2019 (only 8 per cent think it will decline, with the remainder undecided), and 27 per cent anticipate assets under management in these strategies will increase by 30 per cent or more.
One of the key reasons for this growth is that 27 per cent of IFAs believe investors will increasingly focus on smart beta strategies to enhance the dividends they receive.
Given that smart beta products shift the focus away from pure market cap weightings, the tendency is towards a more fundamental-driven style of investing. As such, smart beta can – and we believe will – play a growing role in helping investors to find quality stocks that pay an attractive dividend.
In recent years, there has been growing emphasis placed on dividend income because of low interest rates and expectations of a low growth environment. Indeed, the first set of smart beta products launched earlier this year by Source in collaboration with Research Affiliates addressed this area.
These new ETFs use fundamental measures to screen out companies in poor financial health, and then from the remaining stocks, select the top 50 per cent in each sector based on their dividend yield. The selected constituents are then weighted by the product of their dividend yield and economic size3, as determined by Research Affiliates, rather than their market capitalisation.
Dividends are certainly becoming harder to come by, too: CDR research4 also showed that 68 per cent of IFAs anticipate that dividends from UK companies will stay the same or decline this year when compared to 2015. Just over half (53 per cent) of IFAs anticipate this about dividends from European stocks, and 64 per cent predict this for US equities.
Given smart beta is relatively new, do IFAs have any concerns about it? Do they anticipate new regulations will be required as the sector develops rapidly?
Around one third of IFAs (35 per cent) anticipate that a growing number of ETFs using smart beta strategies will be launched between now and 2019. However, care needs to be taken when it comes to selecting these: some commentators argue that the term ‘smart beta’ is being misused and over half (54 per cent) of the IFAs we surveyed expect tighter rules to be introduced around what constitutes this term.
Smart beta is often portrayed in the media as a new buzzword or some kind of marketing gimmick. The term ‘smart beta’ does invite criticism, and it doesn’t help that there is also widespread confusion about what it means.
However, the reality is that many investors around the world see the value of smart beta and are increasingly using smart beta within their portfolios.
Recent years have seen an explosion in the range of ETFs offering smart beta exposure. In a single market segment, such as European equities, investors can now choose not only individual country and sector products, but also – for example – exposure tilted towards individual factors such as value, momentum or quality (or combinations of those factors), fundamentally weighted indices, risk-controlled indices and dividend-focused indices.
To understand where a particular smart beta product might fit within their clients’ portfolios, IFAs need to establish whether it is a ‘tool’, to provide tactical exposure to a specific market characteristic, or a ‘strategy’ designed to replace traditional broad beta exposure.
Dominic Clabby is head of UK retail at Source. The views expressed above are his own and should not be taken as investment advice.
1 Research Affiliates defines ‘smart beta’ as those strategies designed to add value by systematically selecting, weighting and rebalancing portfolio holdings on the basis of characteristics other than market capitalisation
2 34 IFAs were interviewed by Citigate Dewe Rogerson during February 2016 on their attitudes towards smart beta
3 Economic size is determined by RAFI Fundamental Index weights, which is based on company factors that are not influenced by share price, such as sales, cash flow and book value.
4 54 IFAs were interviewed by Citigate Dewe Rogerson during February 2016 on their attitudes towards dividends
