Implementing A Popular Approach

March 11, 2015

Strategic Indexing, or ‘smart beta’ as it is more commonly referred to, is set to be the biggest area of growth for exchange traded funds this year, according to consultancy Ernst & Young’s Global ETF Survey, published in November last year.

But who is using smart beta, and how are they accessing these strategies? Is it a product just for the sophisticated investor, or can the retail arm benefit too?

ETF Report UK speaks to three fund managers to answer these questions as well as to discover their smart beta ETF views, how they use the products, what they think could be improved and what the benefits are for investor portfolios.

 

DO YOU USE SMART BETA?
Edward Allen, investment director at Ingenious Asset Management:
Yes, but we are cautious.

It gives us exposure to an underlying theme and to academically tested ideas. But we are still cautious for several reasons. These include fears around backtested systematic trading systems, many of which have not had long ‘live’ track records; high turnover funds, where what you think you own may change; and fears that accounting figures lead to systematic decision making.

Alan Miller, co-founder at SCM Private:
We use smart beta when we can understand the particular tilt being employed; where we can see that the valuations of the underlying stocks are more attractive than a conventional market cap weighted index; and that the extra costs, including trading-related costs, of the smart beta product are reasonable compared to the expected outperformance.

Peter Sleep, senior portfolio manager at 7IM:
About 20% of our portfolios are smart beta investments, across both equity and fixed income. We use funds and futures, we run our own regional value portfolios and we even use ETFs. We mainly seek to exploit the value factor ourselves, but we also use third party strategies like Tobam’s Maximum Diversification index series.

 

WHAT BENEFITS DO YOU THINK SMART BETA ETFS BRING TO YOUR CLIENTS’ PORTFOLIOS?
Edward Allen: A systematic and efficient exposure to a theme at a low cost.

Alan Miller: In essence, much of our portfolio is employing smart beta through our overall asset allocation by tilting to those assets where we see the most value—we can easily buy a value or growth, large cap or small cap strategy, or a particular market, at opportune times and often at much lower cost than many smart beta products. Where our clients can benefit in terms of extra risk-adjusted returns, net of costs, we will use smart beta products.

Peter Sleep: 7IM uses smart beta across all funds, particularly in the equity area, but increasingly in the fixed income area. We use smart beta strategies because we believe the evidence is overwhelming that they add value to our clients through time.

It’s a case of better performance at a lower cost. Some smart beta strategies, or blends of strategies, also help improve the diversification or lower the volatility of client portfolios, but this is not universal.

 

WHERE DO YOU LOOK TO RESEARCH THE STRATEGIES, AND HOW DO YOU BEST IMPLEMENT THEM? IS IT ALWAYS THROUGH ETFS?

Edward Allen: Academic theory is the place to start, and focusing on the evidence for the long term outperformance of any factor. ETFs and actively managed funds appear at the moment to be the best way of capturing this outperformance, although this market is rapidly developing, so it may change.

Alan Miller: Yes, always through ETFs. We research the strategies based on the manufacturer information together with third party analysis from Morningstar, Bloomberg and other tools.

Peter Sleep: We use smart beta futures, funds and certificates, and we put together our own value portfolios, as well as ETFs.

 

ARE THERE ANY STRATEGIES YOU THINK WORK BETTER THAN OTHERS, OR IT IS ENTIRELY MACRO CLIMATE DEPENDENT?
Edward Allen: The environment is an important driver for returns; for example, falling yields tend to positively affect higher-yielding factors such as “value.” However, there is evidence that this same factor has worked over some very long time periods, so the environment is not the “be all end all.”

Allan Miller: There are no hard and fast rules, and this is not macro climate dependent.

Edward Allen: The environment is an important driver for returns; for example, falling yields tend to positively affect higher-yielding factors such as “value.” However, there is evidence that this same factor has worked over some very long time periods, so the environment is not the “be all end all.”

Peter Sleep: There are no hard and fast rules, and this is not macro climate dependent.

All the long-only strategies are dependent on the market direction. You will not go up if the market is going down. You might outperform in a downmarket in a low beta strategy for instance, but you will still be dependent on the market direction. There are some long/short strategies that try to be market neutral—long/short value for instance—but even the results of these strategies are variable.

 

HOW DO YOU KNOW WHICH STRATEGIES WORK IN WHICH MARKET ENVIRONMENT?
Allan Miller: You can look at history, but this of course is a danger. Many smart beta strategies that may work well in certain conditions, normally the recent past, may not continue to do well in all market conditions, normally the next few years. It may just be that smart beta can capture more growth and lower valuation anomalies, which a simple market cap weighted index cannot.

Peter Sleep: With the benefit of hindsight, minimum variance strategies do well in a falling market environment; momentum does well in an upmarket environment, but gets killed at market turns; and value tends to do well across cycles. Value did not do well in strong upward momentum markets like 1997 to 2000, when the big stocks just got bigger.

 

WHICH STRATEGIES HAVE YOU FOUND MOST USEFUL IN THE LAST TWO YEARS, AND WHY?
Edward Allen: We have used a version of the “Aristocrats” strategy, specifically allocating to companies which have consistently raised their dividends over long periods of time. This strategy has the advantage of having relatively low turnover, and hence relatively low trading/implementation costs and a consistent exposure to companies that possess this important discipline.

 

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