Smart Beta ETFs – Why Investors Should Not Ignore Them?

In the global world Smart Beta ETFs has emerged as one of the most exciting and debated investments for past 10 years. Today, smart beta ETFs represents almost 45% of the listed ETFs in US and third of all US ETFs market. These numbers are huge when you know that ETFs now represents largest of investors assets in US and other parts of the world.

We all know what are ETFs and what benefits they provide to investors. Though it’s a small piece yet but emergence of smart beta ETFs may be in line soon and we too get the taste of the same. In India they have been in presence now but  hardly noticed by even financial advisors.

It’s interesting to understand what these smart beta ETFs are and why they have been grasping a major share in world ETFs market –

What Is Smart Beta?

Exchange Traded Funds are based on passive investing strategy. They represent an Index which these funds mirror and generate returns for investors. Here the role of a fund manager is absent and the expense ratio is the least. Also, since they are traded on stock exchange they are able to deliver real time NAVs. All of these features make ETFs a preferable investment option for investors.

A beta on other side is a measure of volatility of an individual security or a portfolio.  The index is given a beta value and individual stocks beta is measured in relation to it to asses how much they deviate from their benchmark index. So a beta of 1.5 will signify that the returns of the stock changes by one and a half times the value of the returns of the market.  Now a “smart” in a smart beta investment strategy is basically an alternative strategy then just index based investing where indices are created only to reflect market activity. In this strategy the companies included in the index are not choosen based on index strategy of market cap or liquidity criteria. Rather they are chosen strategically and with certain weightage. These indices are then rebalanced based on outlook of the markets.

If you look at creation of smart indices they are bit different from the traditional indexes we know. In a traditional index such as BSE 200 or any other the larger companies gets the large share while smaller companies a smaller share. A smart beta index on other hand does not follow market cap principle. Instead the companies in a smart beta index are chosen based on certain factors which can be low volatility, momentum, dividend, cash flow or even size.  This means companies which rank high on the choosen factors will get larger share.  That’s how a smart beta index is created.

Smart Beta ETFs

Smart Beta ETFs are also passive investment funds which follow these smart beta indexes instead of broad market indexes. The objective of smart beat ETFs is to combine the best of active and passive investing. This is achieved by enhancing returns with smart indices while ensuring the benefit of low cost of ETF is maintained.

The Global Presence

Smart beta strategies have grown globally. In US more than 1000 mutual funds now use ETFs and more than 370 hedge fund managers are investing in ETFs. The story is no different in other countries.  The largest Smart-Beta ETF is the iShares Russell 1000 Value ETF IWD with $40.59B in assets.  The assets in Smart Beta ETFs are growing exponentially.  A research published by ETFGI, a leading independent research and consultancy firm on trends in the global ETF/ETP ecosystem have illustrated that in first 11 months of 2017 the net inflow in smart beta ETFs has grown by 22% as compared to 2016.  November 2017 has been 21^st consecutive month of inflow in this category.  Going by these numbers Smart Beta ETFs market share is  going to grow beyond investors’ expectations.

How Smart Beta ETFs is used?

Though smart beta ETFs has gain popularity, even in US the utilization is still majority with institutions. Retail investors have not yet started investing in big way in this category of investing.  Probably Smart Beta ETFs are still to be understood.

Ideally, Institutions i.e. active fund managers, Hedge fund managers and others use ETFs for three objectives- tactical allocation, cash equitization and risk management. A tactical allocation in an active fund management is not easy and involves high cost. If a fund manager has an opinion then moving money from one active fund to another is always a difficult execution. ETFs on other hand make this movement of money simpler which is why active managers are investing in ETFs.

The other use of ETFs has been in managing portfolio risk. Larger funds see cash flows almost on daily basis. In general reaching cash equitization is fairly difficult as all inflow in and out has their timeline. ETFs has been helpful for fund managers in meeting this objective. Lastly with smart beta etfs targeting specific factor which fund manager wish to have exposure is achievable with a lower risk than taking the same risk in complete active fund management.  Thus risk management is one area where ETFs especially smart beta ETFs have been very productive.

How Smart Beta ETFs have performed globally?

The next question which arises is whether all smart ETFs strategies have performed well or much like active funds here also we have laggards and performers. To answer these we will have to study US where the strategy is mostly used.  By looking at the funds and their performance it can be inferred even in smart beta ETFs not all strategies have been able to deliver good performance. There are strategies which have delivered superior performance while there are strategies which have under performed.

Here are the five smart beta ETFs strategies which have been delivering results-

iShares Core Dividend Growth ETF

This is a dividend paying factor where weightage is given to companies which have history of consistently growing dividends and are likely to continue. The fund since inception in June 2014 is up by 38.17% against index rise of 35% in last 3 years.

Vanguard Dividend Appreciation ETF (VIG)

This is also on the same strategy as above and the most popular ETF in this factor. It has delivered return of 114.6% in last 10years against 110.5% of index.

Guggenheim S&P 500 Equal Weight ETF

This is a different strategy where each stock from S&P 500 are equally weighted in the ETF and not by market cap. A more small cap oriented ETF this is up by 128% returns in 10 years against 110% of Index.

PowerShares FTSE RAFI US 1000 Portfolio

Now this ETF benchmark index which selects stocks based on four factors– book value, cash flow, sales and dividends.  It has 1000 stocks where high weightage is given to fundamental factors. In last 10 years it is up by 118% against 110.5% of index.

Guggenheim S&P 500 Pure Value ETF

Here some stocks in the index are based on pure growth and others on pure value strategy. The fund is up by 128% in last 10 years beating the broad markets.

If we dive deep into these these 5 smart beta ETFs then we will find that they follow quit simple strategies rather than any complex combination. But there are smart beta ETFs in the same market which have failed miserably. iShare Emerging market Dividend ETF, iShares MSCI Japan Small-Cap ETF, PowerShares S&P 500 Low Volatility ETF, are name of some of the ETFs which have not been able to deliver returns.

Thus even in US it’s the simple understandable ETFs which has been the start performers while any complex strategies have actually failed to deliver returns.

Indian Scenario

Indian does not have many smart beta Indexes. IISL the subsidiary of NSE which provides major indices of ETFs has Nifty Value (NV20) smart beta index based on value theme and comprise 20 most liquid companies of NSE. Here stocks are selected on the basis of value parameters like Return on Capital Employed (ROCE), Price to Earning (PE) ratio, Price to book value (PB) ratio and Dividend yield (DY). The base of the Index is CNX Nifty, which is the benchmark index of India.

Coming to smart beat ETFs there are few of them available to investors. Edelweiss Nifty Quality 30 ETF is a Smart Beta ETF which track Index based on specific factor like high ROE, Low debt to equity ratio and rising year on year profit after tax. We have also Smart Beta ETFs from Reliance, ICICI and Kotak which are based on NV 20 index.   The oldest of all Smart Beta ETFs in India is Reliance Dividend Opportunities Funds which track CNX Dividend Opportunities Index and is present for last 3 years now.

 Performance

Smart beta ETFs in India does not have a long history since its being 3-5 years when they were introduced in India. The oldest of them is Reliance Dividend Opportunities ETF while rests are fairly new. Since ETF itself has not generated enough interest in India from retail investors smart beta ETFs corpus is fairly low.

Source:moneycontrol.com

Looking at the performance chart above it can be inferred that most smart beta ETFs have generated 30% plus returns in last one year. The oldest of them Reliance dividend opportunities has generated 10% annualized returns in last three years. So performance is a boosting factor for them. However, the waters are yet to be tested in the long term.

The Cost

Not much information is available on the cost of these ETFs but through discussions it is estimated to be somewhere between .3-.5% which is a bit higher than traditional ETFs. But if compared with active investments it does throw a huge difference and so these ETFs are well positioned to provide the benefits they are made for.

Should You Invest

Exchange traded funds are surely going to ride the next wave. We have seen mutual funds companies laying their focus and it’s no sooner that more smart beta ETFs will emerge in India. Surely the cost is higher than ETFs but way lower than active funds which can create a difference in return not to be left out by investors. Also, much like other ETFs the reliance on fund manager is not there which makes them an ideal passive investing avenue.

Having said that still smart beta ETFs track indexes which are based on certain factors or you can call them theme. There may be time when these themes or factors do not pay off and the ETFs under perform. Then unlike active funds the strategy cannot be changed to sail through such times. Hence, the investors have to be  aware of the risk they carry. But by and large these ETFs with majorly passive investing strategy can grasp a good share in investors portfolio.

Smart beta ETFs provide a good risk management tool with a passive investing strategy. It’s expected that they will give very stiff competition to active fund management. For investors it will be wiser to be on their toes and do a well research before considering them for investments.

This article has first appeared in Financial Planning Journal, May 2018.