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

'Smart beta' funds give you a chance to beat the market without the high charges of actively-managed funds. Matthew Partridge explains, and picks one smart beta fund worth considering.

stock-trader

Few fund managers consistently beat the market

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

dividend

price/earnings (P/E) ratio

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

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

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.

Our recommended articles for today

Waiting for the big one'

How to cut your tax bill

Recommended

Markets may have bounced, but this is not the end of the bear market
Stockmarkets

Markets may have bounced, but this is not the end of the bear market

Stocks are back on the rise, commodities and precious metals prices are up – even the pound has rebounded. But none of this is typical of bull markets…
5 Oct 2022
What to do as the age of cheap money and overpriced equities ends
Investment strategy

What to do as the age of cheap money and overpriced equities ends

The age of cheap money, overpriced equities and negative interest rates is over. The great bond bull market is over. All this means you will be losin…
29 Sep 2022
Three ways to invest in Japanese value stocks
Japan stockmarkets

Three ways to invest in Japanese value stocks

Japanese stocks have fallen out of favour with investors, but they are looking ripe for recovery, says Max King.
28 Sep 2022
There is light at the end of the tunnel for investors
Sponsored

There is light at the end of the tunnel for investors

Investors are gloomy. But it’s not all bad, says Max King – the mood could be about to shift. You just need to hold your nerve for a little while long…
27 Sep 2022

Most Popular

Should you take a 25% tax-free pension lump sum in instalments?
Pensions

Should you take a 25% tax-free pension lump sum in instalments?

Taking out a 25% tax-free lump sum sounds appealing but it might not be the best way to manage your pension
30 Sep 2022
October’s Premium Bonds: how to check if you are a winner
Savings

October’s Premium Bonds: how to check if you are a winner

NS&I has added almost 110,000 more prizes to October’s Premium Bond draw – are you a winner?
4 Oct 2022
Section 75 refunds: protection for your credit card purchases
Credit cards

Section 75 refunds: protection for your credit card purchases

Under Section 75 of the Consumer Credit Act 1974, your credit card can give you extra protection when the goods or services you buy fall short of your…
23 Sep 2022