The profits on the middle ground

Between passive trackers and active management lies smart beta', says David C Stevenson.

Last time, I risked your wrath with the horrible technical term smart beta'. I'm sure that more than a few of you felt your eyes glaze over, and found the thought of advanced root canal work suddenly more appealing but my use of the jargon was in a good cause!

Investors can increasingly use easy-to-trade, low-cost, exchange-traded funds (ETFs) as an alternative to active fund managers (the beta' bit) but in a rather clever way that helps to control risk in a portfolio (the smart' bit).

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To repeat the key point from last time: in the past, actively managed funds charged you higher fees for picking stocks, rather than just tracking a benchmark. Their aim was to deliver better returns while taking less risk.

This was achieved by using a specific investment strategy, or style tilt'. For example, the manager might only buy stocks with a high dividend yield, or those with robust balance sheets.

Smart beta does this too, by following systematic rules to pick stocks with specific attributes. Better yet, it does this at a lower cost, and without any of the behavioural flaws fund managers are prone to.

For example, those poor bullied active managers might be under pressure from their bosses to conform to market behaviour, and may change how they run the fund over time.

So smart beta offers a middle ground between traditional passive funds and active management.

But what to buy? I have three suggestions this week. The first is for the more value-orientated among you (those who like to buy good-quality equities at a decent price).

I'd focus on the fundamental indices devised by Rob Arnott and Jason Hsu of US-based Research Affiliates, and in particular the Powershares FTSE RAFI UK 100 ETF (LSE: PSRU).

RAFI were the first players in the fundamentals-driven, smart-beta revolution and, when it comes to value investing, they are still probably the best, bar Andrew Lapthorne over at Socit Gnrale.

RAFI uses four fundamental measures of company size: book value, cash flow, sales and dividends. It weights its indices based on these fundamentals. So the stock with the highest fundamental value gets the biggest weighting, while the one with the weakest fundamental value gets the smallest.

According to ETF whizz Simon Smith, of www.etfstrategy.co.uk, you get a portfolio, "which, when compared to a market-cap-weighted equivalent, underweights overpriced stocks and overweights undervalued stocks". This portfolio tends to tilt towards both value stocks and small-caps.

Better yet, says Smith, "when value stocks are out of favour and thus are cheap, the strategies tend to increase their allocation to deep value stocks. When value is in favour, the value tilt is much milder because these stocks tend to be priced higher. Rebalancing into unloved stocks and out of the most popular stocks is... essentially a contrarian strategy."

Be aware that there are some potentially big disadvantages: the portfolios can become concentrated in a few large positions, while overvalued stocks can also become overweighted during different stages of the stock-market cycle.

But overall I think the RAFI indices are first rate, and I'd highly rate their emerging markets variation too: Powershares FTSE RAFI Emerging Markets (LSE: PSRM).

Those who are more adventurous and want to invest in firms that are cheap and growing at a decent rate should look at First Trust UK AlphaDEX (LSE: FKU).

First Trust's highly successful AlphaDEX strategy, which has been around in the US for a while, aims to take the best of both value investing and growth investing (ie, stocks with fast-growing profits).

According to First Trust, the index screens UK stocks for "growth factors including three-, six- and 12-month [share] price appreciation, sales to price [ratio] and one-year sales growth". It also looks separately at "value factors, including book value to price, cash ow to price and return ona ssets".

What it boils down to is that you get the best of all worlds decently valued stocks with solid earnings growth. Last time I looked in the summer, that meant a weighting towards the likes of budget airline easyJet, equipment rental group Ashtead and housebuilder Barratt.

Last but not least comes the Ossiam ETF FTSE 100 Minimum Variance ETF (LSE: UKMV).

The ETF has consistently beaten its peers since its launch in January 2012. It aims to deliver the return from the FTSE 100, but with reduced volatility.

In technical terms, the index picks and weights stocks based on their forecast risk and inter-correlations to build a lower-risk portfolio. In practice, you end up with an index that is less exposed to volatile stocks such as energy and mining stocks (plus banks), and more exposed to industrial goods and consumer companies.

In short, you end up with a more defensive index tracker focusing on British stocks you know and love, but in a cheap, cost-effective wrapper.