Due Diligence Critical As Smart Beta Grows

Smart-beta ETFs can provide diversification and innovation to a portfolio, but they also come with baggage—more due diligence and the need to learn about how they work.

Andrew Clare, professor of asset management at Cass Business School, and the associate dean responsible for Cass Corporate Engagement, will be presenting the evidence from his four groundbreaking smart-beta research papers at the Inside ETFs Amsterdam conference.

Clare, who has previously worked for the Bank of England as well as a financial adviser, says there is still a big gap in adviser knowledge that needs to be filled. He warns that only a "limited number" of smart-beta strategies work, and that smart beta within fixed income is still a long way off.

You can catch him at the conference at the Okura Hotel 13-15 June.

Can you give us a sneak preview of these smart-beta papers, sponsored by Invesco, and what they show?

Andrew Clare: Sure. We knew there was confusion regarding what smart beta was about, and Invesco asked us to write a series of papers to illustrate how investors could add these solutions to their portfolios.

In the first, we lay out the academic research and evidence for smart beta, which has been going on at institutions and business schools for over 40 years. We wanted to give investors an idea of the pedigree of smart-beta approaches—like value, factor-based, small-caps, etc.—in an academic paper. 

The second paper proves that not everything that’s called smart beta is actually that smart. If you’re invested in a product that’s just been launched by a marketing team, you should investigate whether the strategy has been established and tested in the academic literature.

As for the third, today we have various key smart-beta elements, but can we put them together to produce a smart-beta portfolio? So we looked at approaches as to how to develop and implement that.

The final paper addresses the issue of due diligence with regards to smart-beta investing.

That’s an interesting topic. Can you expand on the due diligence paper?

Clare: We analysed what the difference is in terms of due diligence for an investor who is either invested in a traditional, active fund, or in a rules-based, smart-beta approach. What questions do you have to ask? What are the differences in terms of monitoring? How can you measure whether your chosen smart-beta strategy is acting as you expected, or performing as you want?

I think they are important questions to ask, as some people believe a rules-based fund will just take care of itself. But that’s not true, really. You need to make sure the fund is tracking the index accurately and that the manager has the skill to do that.

The due diligence required is admittedly lower than for an active fund, as ultimately there’s a difference between a discretionary approach with a human picking stocks, and rules-based investing, and as long as you can be sure the manager is following the rules, you don’t need to be worried that the ETF manager’s skill will dip in the next quarter, or that they will leave the fund house altogether. 

How can advisers really do due diligence on an ETF, especially if it’s a new fund?

Clare: Some smart-beta approaches have a 30- to 40-year research track record, so you should investigate whether something works based on that research, independent of whether it’s being touted as a great investment idea by a fund manager.

So if someone says: ‘I’ve got this great investment idea—to track an index of companies whose CEOs are under 5 foot 6 inches.’ Is there any obvious reason that should be the case? Is there any fundamental reason I can think of as to why small CEOs would tend to generate more profit? Adopting a more critical approach would be a good starting point.

Have we reached a plateau of innovation in smart beta?

Clare: Quite a lot of so-called new ideas are just variations on the same theme. There is a limited number of smart-beta approaches that work, and it’s just a question of how fund managers and index providers package them and market them. Having said that, I wouldn’t be surprised to see more innovation over the next year or so.

What is the most common myth you need to debunk regarding smart beta?

Clare: I’m not sure I would call this a common misconception, but I would point to the general ignorance—if I can call it that—of smart beta. There is so much out there, and it’s so difficult to know what is on offer and why. It’s knowing how to analyse these strategies and products and how to select them in the first place.

Vanguard launched a four-strong smart-beta ETF suite in December, with annual fees as low as 0.22%. Will that move set a trend for lower smart-beta ETF costs?

Clare: Yes, I think so. It’s generally difficult to justify charging active fees, or fees that are closer to active, for a rules-based, computer-based approach to investing. I definitely think there is and will continue to be a trend for lower costs.

Can you make a smart-beta ETF portfolio work by picking individual risk-factor ETFs?

Clare: It depends how the factors are combined. If there is any sense of a discretionary manager in the process, that could be a problem, but if it’s a rules-based approach, then the strategy has potential for getting the best out of a number of smart-beta approaches.

But what about multifactor ETFs, which combine, say, value and momentum within one index?

Clare: I would need to see the evidence for that. I was referring more to picking smart-beta ETFs and rotating between them.

Do you have any advice on how an adviser could dip their toes into this market?

Clare: Read papers one and two of ours, at least, or papers from another independent source, because that starts you off with the basics. 

But should smart beta only be a small part of your portfolio? Not necessarily. Talking about equity investing, I don’t see any reason smart beta couldn’t make up 100% of your allocation.

Is this the end for market cap?

Clare: No. Market cap will always be there, as it’s so convenient, and really, in terms of scale, there’s no limit to how much money can be allocated that way.

What about smart beta in fixed income?

Clare: It’s in the very early stages. Equity smart-beta investing has been around now for about 10 or 12 years. In fixed income, it’s much more difficult to establish similar approaches to investing, mainly because liquidity is more problematic. Maybe in 10 years’ time, fixed-income smart-beta approaches will be where equity smart-beta approaches are today.