Smart beta funds: The best of both worlds

Smart beta funds can give you the benefits of active management, but with much lower fees. David C Stevenson looks at four such funds.

Can you get the benefits of smart active management with the low fees of trackers? Now you can smart beta funds. Here are four to investigate.

One truth in investmentthat bears repeating is that not all shares are created equal. Mathematically orientated investors (known as quants)have long realised that certain types of stocks tend to outperform the overall market over time, and to beat benchmarks such as the FTSE 100 index.

Academics refer to these traits that seem to be linked to performance as factors'. While there is a large and growing body of research on what factors are important, there are four that are well known and widely followed. These are:

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Quality. Buy good businesses where profits have been growing steadily and balance sheets are strong.

Value. Buy out-of-favour stocks where the share price doesn't truly represent the underlying value of the business.

Size. Buy a mix of small- and large-cap stocks, because small caps have a tendency to outperform their bigger brethren over the longer term.

Momentum. Buy stocks whose share price has been increasing in value more than the benchmark.

Active fund managers often use complex stock screens to try to identify companies that have these winning characteristics. But active fund management comes at a cost. A typical actively managed fund might come with an annual management fee of 0.75% or more.

By contrast, a cheap exchange-traded fund (ETF) might cost you half or a third of that. So the obvious question is whether there is a way to hitch the low fees of using ETFs to the strategy of investing in these types of stocks.

In other words, ditch the active managers but keep the benefit of the kind of factors they look for. And the good news is that there is.

Introducing smart beta

The first step is to create an index that includes stocks with the kind of factors that you want and weed out those with the qualities you don't. Doing this can have a surprisingly big effect on returns.

Historical data shows that, by excluding the trash' stocks that are too volatile, loss making and profoundly unloved, you could have got an extra 0.5% to 2% per annum in returns over the long term. There's no guarantee that this will continue, but the outperformance of some of these factors has been resilient over time, so there is reason to think it will.

This idea is known in the industry as smart beta', or strategic beta'. I think it's an important principle for how we build our portfolios. For example, if you're a relatively cautious person investing for the next 20 years, you might tilt' another bit of industry jargon towards higher-quality companies. This should combine a good chance of outperforming the market with lower volatility.

Investors who are more adventurous might have a higher weight in small caps. More tactically inclined investors ie, those who like to rebalance their portfolio frequently to reflect shorter-term trends could focus on the momentum factor. You might buy momentum stocks to go bullish when markets are bullish overall and then sell them when markets turn bearish.

Of course, for this to work you need to be able to implement these factors in your portfolio as simply as possible. The obvious solution here is ETFs that track a smart-beta index, rather than a traditional index such as the FTSE 100.

Cue iShares' new range of smart beta ETFs, all tracking a variation of the big, standard, core MSCI World equity index of developed-world markets delivered to your portfolio with a total expense ratio (TER) of 0.30% per annum per fund.

A checklist before buying

American analysts at research firm Morningstar have been tracking the rise of smart beta for quite some time and they've just produced a fascinating report looking at the growth of these factor-based funds. While it may be a bit technical in places, it's well worth a read. It's called A Global Guide to Strategic-Beta Exchange-Traded Products.

Most importantly, the Morningstar analysts include a checklist for investors looking to invest in these smart-beta funds. They reckon you should evaluate funds against the following criteria:

What does this fund do? Find out which index it tracks and read the methodology document.

Does this fund attempt to leverage a well-known factor?

What kind of stocks does the fund own? Is it biased towards certain sectors? Is it biased towards certain styles (for example, value or growth)? Is there a focus on quality and profitability? Does it lead to a concentrated portfolio (one with a small number of holdings)?

Are there other funds that offer similar exposure? If so, how does the fund's expense ratio and portfolio compare?

Has the fund performed as expected? Check its performance relative to peers.

What kind of risks does it exposeyou to?

The four new ETFs to buy now

While ETFs like this have been available to investors in America for some time, the UK market has lagged behind.So it's worth looking at these new launches in a bit more detail.

Perhaps the most adventurous is the MSCI World Momentum Factor ETF (LSE: IWFM). According to iShares, the index this ETF tracks focuses on stocks that have "experienced price increases over the past six and past 12 months, with the assumption that increases will continue in the future". In other words, it favours stocks that are already going up strongly.

The MSCI World Value Factor ETF (LSE: IWFV) tracks an index of stocks selected on the basis of three widely used metrics of value. These include the forecast price/earnings (p/e) ratio, the price/book ratio, and the ratio of the company's enterprise value (the value of its debt plus the market value of its equity) to operating cash flow.

This means that it reproduces some of the classic value-investor screens in index form.The third fund is my own favourite the MSCI World Size Factor ETF (LSE: IWFS).

As iShares puts it, this includes "the mid-capitalisation constituents of the [MSCI World] index but, at each rebalance date, all index constituents are weighted equally, effectively removing the influence of the size of each constituent's market capitalisation".

The key point of this is that smaller mid-cap companies will have a larger weighting in this index than in the main MSCI World index.

Studies suggest that equal weighting an index (giving those smaller-cap stocks a greater weighting) delivers consistent outperformance over the very long term. By contrast, some factors such as momentum will often do well while markets are rising, but in other conditions the outperformance from this factor vanishes.

Nonetheless, returns from investing in smaller companies can be much more volatile than the overall market. So don't buy this if you are concerned about the risk of losing 10%, or even 30%, in value in one year.

Lastly, the most balanced' offeringfrom this range is the MSCI WorldQuality Factor ETF (LSE: IWFQ), whichfocuses on stocks with a high returnon equity, low levels of debt, and lowearnings volatility. As a result, theportfolio is biased towards big, profitablelarge caps, such as Apple, PepsiCo orUnilever.

This could make it especiallyattractive to investors who favour adefensive tilt to their portfolios. In myview, this mini range of factor ETFs fromiShares is compelling value at 30 basispoints.

If I was building my portfolio fromscratch, I'd be tempted to use theseproducts as the core building blocks, iedump your standard benchmark trackersand use these instead.

Factor ETFs will never blow the lightsout, but if assembled properly withina diversified portfolio they could giveyou a consistent small gain above thebenchmark return over the long term,especially given the low fees.

David C. Stevenson

David Stevenson has been writing the Financial Times Adventurous Investor column for nearly 15 years and is also a regular columnist for Citywire.
He writes his own widely read Adventurous Investor SubStack newsletter at

David has also had a successful career as a media entrepreneur setting up the big European fintech news and event outfit as well as in the asset management space. 

Before that, he was a founding partner in the Rocket Science Group, a successful corporate comms business. 

David has also written a number of books on investing, funds, ETFs, and stock picking and is currently a non-executive director on a number of stockmarket-listed funds including Gresham House Energy Storage and the Aurora Investment Trust. 

In what remains of his spare time he is a presiding justice on the Southampton magistrates bench.