Opinion – Smart beta not what it seems

11-Aug-2017

By Chris Brycki

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Promoted as a new way to diversify and reduce risk, smart beta aims to combine elements of passive index investing and active fund management to deliver the best of both worlds - transparency, broad diversification and market-beating returns at a low cost.

It sounds amazing, but as is the case with most investment products that try to beat the market, if you take a look under the hood you will find it’s not so simple.

All index funds, by definition, are passive investments, including smart beta. There’s no fund manager picking stocks; buying and selling is done per a strict set of rules.

Smart beta indices aim to fix some of the believed shortcomings of weighting investments by market size - which is what traditional exchange traded funds (ETFs) do - by instead considering other factors like dividends, value, revenue or cash flows.

The issue with smart beta is that to offer more exposure to some factors like value and dividends, smart beta strategies must de-prioritise other factors. It’s essentially betting that a few select factors are more important than an all factor, or market value approach.

While it is often marketed as being able to ‘beat the market’, the truth is murkier. Many smart beta ETFs have only outperformed from back-testing over a select historical period, which introduces some significant issues including period selection bias.

As the old joke goes, I’ve never seen a bad back-test.

Let’s say a new smart beta ETF weighted companies according to chief executives whose name started with the letter ‘S’ and found this new index outperformed a market weighted index by 10 per cent over five years. This is not because Stuarts and Stevens are superior to other chief executives - it’s an example of how you can use a random set of data to prove any hypothesis when back-testing.

This is the danger of smart beta. Smart beta funds promoting strong back-tested performance typically select a time period that best supports their product, and over the long run higher fees may erode any benefit.

Many smart beta funds launched in recent years are dividend focused as dividend strategies had a great performance between 2011 and 2014. ETF issuers know it’s easier to sell strategies that have done well recently over those that haven’t, as people tend to chase returns.

However most of these smart beta dividend funds have underperformed the market weighted ETFs since they launched.

Stockspot’s annual Australian ETF Report analyses the ETF universe including smart-beta funds. It shows that some of the most heavily marketed assets, funds and sectors were among the worst performing in the 2017 financial year.

Smart beta ETFs had mixed performances compared to the traditional market cap weighted ETFs, which we prefer for Stockspot strategies.

Investors considering smart beta ETFs should be careful to consider more than just recent performance in their decision. Chasing what has already done well in the past is rear-vision mirror investing and not likely to be a successful strategy.

This is why we typically avoid smart beta funds.

Chris Brycki is founder and chief executive of automated adviser Stockspot

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