Smart beta – the next great fund management gold rush

Stockmarket indices once a useful but dull corner of the investment world are big business these days. Major index providers, such as MSCI or S&P Dow Jones, are worth billions of pounds. This is largely down to the rise of passive investing and exchange-traded funds (ETFs), which track various indices on a daily basis. Investors are also demanding ever-more sophisticated indices that can replicate key investment strategies, leading to the next great fund management gold rush smart beta.

A smart beta index makes use of 'factors' that have been found to boost returns over time they screen for stocks that are cheap (in relative share-price terms) or boring (in terms of volatility), for example. They promise the benefits of passive investing low cost, simple to understand and less volatile but also the better returns you might hope for from good active management.

More active than you think

Most smart beta indices fall into four categories. Value indices focus on how cheap a stock is, using ratios such as the price/earnings ratio. Momentum-based strategies track a share's strength against the wider index. Quality strategiesmight look for shares with low volatility.

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

And dividend-based ideas focus on yield. A quarter of big institutions (those with more than £1bn under management) already use smart beta, and another 40% are considering it, notes French business school EDHEC. Mostfavour either low volatility or value investing, and they aren't looking to replace traditional active managers. Instead, smart beta helps to prevent overexposure to just a fewvast businesses within a given index.The indices also allow managers to combine different factors to help improve returns over the stockmarket cycle.

No fund for all seasons

Factor-Based v. Industry-Based Asset Allocation: The Contest

The study compared smart beta indices with traditional sector indices (those that track just banks or miners, for example) in varying economic and market backdrops. Smart beta was more profitable during "expansion times and bull periods... however, sector investing delivers better or less bad performances for long-only portfolios during recessions and bear periods". Other evidence echoes this research that different factors and indices work better under different market conditions.

Lyxor index experts Thierry Roncalli and Jean-Charles Richard examined which smart beta factors worked best in each of the last seven years. To cut a long story short, they found that it varies dramatically. For example, indices that favour small caps beat the market in 2014, but massively underperformed in 2012; low beta indices were stars in 2008, but has-beens in 2013. So investors need either to diversify across smart beta strategies, or carefully time their switching between them.

The cost of 'smart' indexing

From 1995 to 2015, a value version of the MSCI World index had 30 times more changes than the standard index. The resulting trading costs inevitably hit returns: the analysts estimated that, over the same period, the total cost of a value-based version of a world stocks index was 99 basis points (0.99%), versus less than one basis point (0.01%) for the traditional index.

Their advice? It makes sense to use the concepts behind smart beta, such as value or momentum investing but the indices themselves aren't necessarily the best way to do it. For example, it's not sensible to rebalance your holdings on the same day as everyone else, which is effectively what these indices do if everyone is selling a share that's been ejected from the index to buy one that's been promoted, the price of the former will be artificially depressed while you'll pay over the odds for the latter. In short, don't be swept away by the hype before you invest, make sure you understand the index, and realise that smart indexing nearly always comes with a cost.