Beat the market with 'smart beta'

Last week I wrote about how traditional passive investing isn't quite the perfect solution to the problems inherent in our efforts to make long-term returns that some like to think.

Instead, as it effectively forces investors to buy high and sell low, it has a long-term deadening effect on potential returns. On the plus side, increasing volumes of research show that if, instead of simply tracking stocks in the usual indices weighted by price, you weight the stocks in any given index by their fundamental characteristics you have a reasonable chance of outperforming.

The key point here is that there is a middle way in investing. One in which you actively choose an investing strategy likely to be good and you then enact it passively. Say you decide to invest in the FTSE 100, but rather than deciding how much to hold based on the size of the companies in it, you do it based on dividend yield.

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You would then hold all the same stocks as anyone with an ordinary tracker but instead of holding more of the expensive ones and fewer of the cheap ones, you would hold more of the ones with a high dividend yield and fewer of the ones with a low dividend yield. The same would happen if you ranked the stocks by cash flow or sales.

This makes phenomenally good sense to me. All studies show that value investing beats most other strategies over long periods of time. All fund managers know this and the vast majority claim one way or another to be value investors.

So the fact that they also mostly consistently fail to beat traditional indices can only be put down to the fact that due presumably to the usual parade of human errors and short-term pressures they don't actually invest as they know they should. Choosing to use a computer to make the stock picks and so to enact your strategy takes that problem away.

I didn't offer you any suggestions for funds that do this last week, but the good news is that there are increasing numbers around (the key words to look for are fundamental trackers or smart beta funds).

The US is, as ever, rather ahead of us, but we are slowly catching up. Only this week, First Trust launched three exchange-traded funds (ETFs)based on what they call 'AlphaDEX Methodology'. This isn't as simple as I suspect some of us would like, but it does firmly walk the middle way in that it creates a rules-based strategy (the active bit) and implements it rigorously (the passive bit).

The idea is to take the constituents of an index and rank them based on six factors (these include all the obvious ones price to cash flow, price to book value, return on assets as well as some that nod to growth investing styles such as sales growth). The lowest scoring stocks are dumped and the others weighted based on how they have scored on the six criteria used. The process is then repeated semi-annually and the holdings rebalanced accordingly.

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In the UK, you will now get to choose from three indices "enhanced" (as First Trust like to say) in this manner. There's one based on the FTSE 100 (First Trust United Kingdom AlphaDEX), one on the S&P 500 (First Trust US Large Cap Core AlphaDEX) and one on the MSCI Emerging Markets Index (First Trust Emerging Markets AlphaDEX).

These sound very tempting to me particularly given that their history suggests they might just work. In the US, First Trust runs 39 of this kind of ETF. Sixteen have been going for five years (ie, long enough for us to consider their records to have long-term relevance) and the average outperformance of those over their benchmark indices is 1.5% a year after fees.

That might not sound like much but, as anyone who understands compound interest will know, it is. Invest £20,000 for ten years with an average annual return of 5% and you'll end up with £32,580. Make that 6.5% and you'll have £37,540. That's over 15% more.

The funds are not rock-bottom cheap relative to bargain-basement trackers, but on total expense ratios (TER) of 0.80%, they are very cheap relative to most actively managed funds. Another middle way.

Other options in the UK include the Powershares "Intelligent Exposure" range ofnine ETFs based on the FTSE RAFI indices. These are another import from the US the idea of dedicated fundamental index investor Rob Arnott of Research Affiliates. They focus entirely on value weighting stocks by sales, cash flow, book value and dividends and have generally impressive performance records (relative to ordinary trackers as opposed to the best of the active funds) as well.

Finally, for those only interested in tracking dividend stocks, there are a few other options. The UK's most dedicated fundamental indexer has to be Robert Davies of Fundamental Tracker Investment Management. He runs the Munro UK Dividend Fund which weights by gross cash dividend payments (something that gives it a clear bias to value).

Those equally (and quite rightly) obsessed with dividends might also look at the iShares FTSE UK Dividend Plus and the S&P US Dividend Aristocrats, both of which I very happily hold in my own Sipp.

This article was first published in the Financial Times.