Franklin Templeton has built its name on the merits of active management but recently unveiled plans to roll out ‘smart beta’ exchange-traded funds (ETFs) to the UK market, saying this combines the best of active and passive management. 
Earlier this month, the group said it would list four smart beta ETFs on the London Stock Exchange. Two of the LibertyShares ETF products will focus on stocks that demonstrate “high and persistent dividend income”, the third will look at US large- and mid-caps and the fourth will hold global equities considered to be environmentally and socially responsible.
The group said it has been a vocal advocate of active management “for decades” so why has it chosen to launch a range of passive funds for UK investors?
Chandra Seethamraju, director of systematic modelling at Franklin Templeton Solutions, argued that the emergence of risk-factor investing and the evolution of traditional indices have led to new opportunities to bring the human touch to what has traditionally been considered a rather automated space.
Seethamraju pointed out that computers are replacing human decision-makers in many areas of modern life. Interactions such as recommendations when shopping online, suggestions for music on streaming sites or potential matches on dating apps are all built on algorithms.
Global smart beta adoption rates
Source: 2017 FTSE Russell global smart beta survey
“At the heart of each example is a human decision-maker who has constructed the framework in which the algorithm operates,” he explained.
“The more skilled and intuitive the human designer, the better the potential outcome for the human user. As a company with its global headquarters in California’s Silicon Valley, we think we are more aware than most of the power and potential of algorithms and technology to simplify and improve modern life.”
“We recognise and embrace the valuable interplay of humans and technology. It’s one of the reasons why we have historically been vocal advocates of active investment management – and still are – even as passive, index-based approaches have grown in popularity.”
When it comes to index investing, traditional indices are weighted by market capitalisation. Seethamraju said that this contains certain biases – for example it is, by its very nature, backward-looking – but smart beta offers a way to avoid this.
“Rather than honing in on stocks with potential opportunity, [traditional indices] reflect stocks that have performed well in the past, stocks that have traded at high multiples or that belong to popular industries. Conversely, active management strives to identify potential and apply it,” he said.
In essence, traditional market-capitalisation indices reflect a hands-off approach. Smart beta, on the other hand, employs criteria (or factors) other than market cap, with potential approaches ranging from relatively simple – such as equally weighting stocks – to more complex – like identifying stocks that combine multiple attractive features.
“One of the simplest approaches holds securities in equal weights, rather than weighting them by market capitalisation,” Seethamraju added.
“Meanwhile, a quantitative approach systematically analyses, selects, weights and rebalances portfolio holdings based on certain investment style characteristics known as factors.”
These factors are primary characteristics of an investment that explain its behaviour over long periods of time. A smart beta portfolio can focus on a single one of these while others combine many. To simplify things, Seethamraju thinks of factors as being the DNA marker of an investment that causes it to respond to certain events.
“It drives the investment to behave the way it does over time,” he said. “Stocks can be grouped based on the primary factors they share. Some factors have provided investors with positive returns above and beyond market indexes over the long term, called a ‘return premium’.”
Factors that could have generated this return premium include:
- Quality, or businesses with stable earnings growth
- Value, or companies that are attractively priced relative to historical and forecasted valuations, and historically have paid attractive dividends
- Momentum, or stocks that have demonstrated strong performance over the past six-to-12 months
- Volatility, assets that have demonstrated lower-than-average variability of returns
What type of smart beta strategies are investors currently using?
Source: 2017 FTSE Russell global smart beta survey
Of course, the investment industry has witnessed many fads over the years and there are some who believe that smart beta is just another example. Seethamraju firmly rejects this view and sees the method as being an important evolution in investment.
“We see the smart beta ETF as an advancement in the binary world of passive and active management,” he said.
“To us, advancements in index construction and portfolio design represent an opportunity for investors with the right tools and expertise to potentially improve risk-adjusted investment performance over time.
“This is something many investors would likely find attractive. We perceive an opportunity to apply further enhancements to smart beta. This involves bringing the research skills, experience and insight honed in an active management sphere to the strategic construction of sophisticated indexes.”
Seethamraju added that while market cap-based indices have served a useful purpose as indicators of broad market performance and as benchmarks against which to measure active manager performance, a rules-based index design that analyses individual stock exposure to specific factors provides a more advanced, forward-looking – and more nuanced – approach to targeting specific market outcomes.
“Even an index determined by market weights is exposed to factors such as quality, value, volatility and momentum,” he continued.
“For index funds, these exposures are determined by the stock market’s ups and downs on which market-cap indices are based.
“We believe that for most investors, particularly those seeking an outcome other than market exposure, it’s preferable to plan for factor exposure, rather than be subjected to it by market fluctuations.
“We think a systematic factor approach offers the advantage of always knowing exactly which factors are driving your index’s returns.”
Such an approach combines the appeal and intuition of more sophisticated passive approaches – transparency, diversification, a rules-based methodology and lower costs – with the prudence and perspective of an active manager who uses research to determine specific exposures that pursue a desired outcome, he said.
“That’s why we believe an index designed and constructed on risk factors should not neglect the most important factor of all: the human factor,” he finished.