How to get the benefits of active fund management on the cheap

Here at MoneyWeek, we’re big fans of passive investing.

Some fund managers can beat the market on a consistent basis. But they are vanishingly rare. The benefit of passive funds is that you know what you’ll get – the same return as the underlying market, less a relatively small management fee.

Indeed, even legendary US investor Warren Buffet intends to invest part of his wife’s legacy in passive funds.

However, passive funds aren’t perfect. There is plenty of evidence that some investment strategies – buying ‘value’ stocks, or ones paying high dividends – tend to outperform others over time. A traditional passive fund simply follows the index, and so can’t benefit from these strategies.

The good news is that there is a way to get the best of both worlds.

Active management at a passive price

Some investment strategies have been shown to work better than others pretty consistently. For example, a basket of high-dividend shares tends to outperform those with a lower-yield. Similarly, shares with a high price/earnings (P/E) ratio tend to have had a hard time living up to their expectations than those with low P/Es.

Traditional passive funds are instead weighted by market capitalisation (the value of the underlying stock). So the more popular and expensive a company becomes, the more you end up buying. ‘Buy high, sell low’ – which is basically what these funds do – is not an investment strategy most of us would opt for, given the choice.

However, a new group of exchange-traded funds (ETFs) do more than simply track the market – and at a much lower cost than traditional funds.

So how do these ‘smart beta’ funds work? Some simply follow an index that is weighted around earnings or dividends, rather than market cap.

How does this work? Imagine there are two shares, both with a market cap of £100m. Company A pays out £3m in dividends a year (a yield of 3%). Company C pays out £1m a year (a yield of only 1%).

A traditional index fund would buy equal amounts of both companies, giving an average yield of 2%. But a dividend-weighted index would have 75% of its portfolio in company A and only 25% in B. This would give a more generous yield of 2.5%.

One downside is that this involves more trading than conventional index funds. This is because they have to be rebalanced regularly to take account of rises and falls in the prices of the shares. But to prevent the extra costs eating into performance, most smart beta funds are only re-balanced once or twice a year.

The ‘smarter’ the ETF, the less attractive it becomes

Other ‘smart’ ETFs follow indices that are built to mirror a specific investment strategy. The big difference between these and conventional active funds is that the decisions are based on a set of rules, rather than being vulnerable to the changing views of the fund manager.

For instance, a fund could decide to buy only the top quartile of the highest-yielding stocks in the FTSE 100. Another popular strategy is based around share price momentum, and involves buying the stocks that have risen the most in the short term, in the hope that they will keep going up.

This allows a more concentrated portfolio that completely excludes shares that fall outside their criteria. The downside is that you are trusting that the computer algorithm will continue to deliver superior returns.

Many traditional managers argue that if you are going to engage in this sort of stock picking, you need to consider a broad range of criteria, including subjective factors such as the quality of the management, when looking at shares.

There is also a tendency for ETFs, especially those based around dividends, to end up being very focused in certain sectors.

The final group is ETFs that use multiple criteria to screen shares, constructing a completely bespoke portfolio. For instance, one ETF from Goldman Sachs claims to rank stocks by “size, value, momentum, quality and low beta”. It further limits the size on each individual holding so that no share is worth more than 0.5% of the total portfolio.

The benefits of this are that the sophistication of the strategies means they won’t be skewed by one factor. However, the strategies are even more opaque than the second group. This allows them to push up fees to levels comparable with human-run funds. Given that the main point of passive investing is to save money, there seems little point in the more expensive funds.

One smart ETF worth considering

Despite these drawbacks, smart beta is becoming an increasingly popular asset class – accounting for nearly 20% of all ETF assets.

While there are certainly a lot of companies jumping on the smart beta bandwagon, or using it as a marketing gimmick, there are some worthwhile ETFs out there.

In our view, a smart beta ETF should meet three criteria. Firstly, it should have low fees and expenses. It should also have a strategy that’s simple and understandable. Finally, the strategy that it uses should have a record of beating the index after fees.

One UK focused smart beta ETF that meets all three criteria is the iShares UK Dividend UCITS ETF (LSE: IUKD). This follows the FTSE UK Dividend + index, which is constructed by taking the 50 highest-yielding shares in the FTSE 350 and then using them to build a dividend weighted portfolio.

It has a total expense ratio (TER) of 0.4% and has outperformed the FTSE 350 over three- and five-year periods.

• This article is taken from our free daily investment email, Money Morning. Sign up to Money Morning here.

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