How investors use 'smart beta'

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The latest hot buzz phrase doing the rounds in fund management is 'smart beta'. Tim Bennett explains what it is, and what it means for you.

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A couple of people have already emailed and said, "Tim, what is smart beta?" There it is, it's an exciting sounding piece of city jargon. So what's it all about?

Now, the first thing I should say is there are a couple of videos out there which I'd urge you to have a quick look at either before or after this one. One is called 'What is alpha?'and the other is called 'What is beta?'I'll be covering that very quickly in this video.

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Smart beta fits somewhere in the middle. So, what is smart beta? Well, in essence this is a fund management type term. What people are doing at the moment is they're challenging whether you want to be an active investor or a passive investor.

Do you pay a fund manager to run a fund for you and do stock selection and stock picking and all that clever stuff, or do you put your money into a passive fund which will be cheaper? That just usually tracks some kind of index or some kind of sector or basket of shares, so the stock picking is much less active, transaction costs are much lower, and fees are lower too.

There's the debate, and smart beta fits right into that debate.

So, you tend to get two sorts of people in fund management and people who buy funds. Some are like what's called active fund management. Active fund management is where you get the term alpha. This is the idea that I should pay a fund manager if I want to beat the market, to choose stocks for me. They will add value for me, they will add that mysterious thing called alpha.

If you're thinking, "Well, I haven't really explained it", do take a look at my other video, 'What is alpha?'

Active fund managers charge higher fees, in return they try and offer high returns. Now, over the passive side of things, if you like, in fund management and fund picking terms you have passive funds.

So, there's a computer, let's call it a simple computer program, strip it right down. All that really offers you is what you might call beta. In other words you can make a cheap fund, you don't need a fund manager. You don't need all the long lunches and the games of golf and the meetings.

What you can do is just program a computer to effect a really simple stock picking strategy. What it might do is simply pick most of the stocks in a big index, not all of them but most of the stocks in a big index like the FTSE 100 or the S&P 500.

So, it will become a S&P 500 tracker or a FTSE 100 tracker. It just literally sort of sits there with a basket of stocks selected by a computer and that's called a passive.

It's a beta style of investment management. In other words beta, and if you look at my video 'What is beta?', really it's about someone saying, "Well, all I'm really going to give you is the return of the market by passively following it."

Whereas over here our fund manager is saying, "I can do better than that. I can do better than just tracking a broad index, I can beat it and offer you value that way, offer you alpha". Now, smart beta, if you like, is a sort of intelligent computer. A smart beta strategy would be a computer with a brain. That's where smart beta fits in.

This has come about because what's happened is this: people have got fed up with paying for active fund management. They've said, "Well, we've had the credit crisis, we had the stock markets falling. What am I paying for? What am I paying for?"

There have been various studies done saying that over time an awful lot of fund managers don't even manage to match the performance of the market, let alone beat it.

There's been a move, I wouldn't say a stampede but there's been a big move into passive style funds, cheaper, lower costs and so on; exchange traded funds, passive unit trusts and investment trusts. There has been a bit of move over here, so an attempt to fight back, if you like.

You could see it this way, the fund management industry is saying, "Well, actually you can have the best of both worlds. You can have the low cost of passive funds but with the kind of brains almost of an active fund. So, we're going to try and give you the best of both worlds."

Now, whether they succeed or not is another matter, but they're calling that in industry jargon smart beta'. You'll see quite a bit of stuff being written about it right now.

The theory basically is this, if all you do is track a broad index and there's been research on this from Cass Business School recently, O'Shaughnessy Asset Management wrote a paper recently.

There have been papers written saying that if you just literally track the market, common sense dictates you're going to be doing something that most investors shouldn't in order to make money because when you track the market what are you actually tracking?

If the market is defined as an index like the FTSE 100 or the S&P 500, those are market capitalisation' driven; a term I deal with in another video. Essentially, the companies in that index are chosen and reselected according to how big they are.

If you think about it, market capitalisation size is a function partly of share price and the number of shares issued. So, if your passive tracker is simply picking companies on the basis of how big they are, part of which is how high the share price is, surely what's happening is you're buying companies that are expensive by being in the index and selling companies that are cheap.

If they've got a weedy share price they'll be booted out. Wait a minute, isn't that the exact opposite of what a profitable strategy should be all about? Shouldn't you be buying the cheap companies and selling the expensive ones?

So, critics of pure passive fund management say, well beta strategies are useless because you might get some gain out them, I mean the market does tend to rise over time but you can do better without paying the fees associated with alpha, active fund management.

I'll give you an example. What does a smart beta strategy look like?

Well, there is a product out there, I'm not advertising it as such, there is a product out there it's called the PowerShares FTSE RAFI that's the ticker, US.PRF, for anyone who's interested that chooses US stocks according to four criteria; book value, sales, dividends and cash flow.

It tries to build an index of stocks without just slavishly going for market capitalisation based selection. That's an example of smart beta.

Now, does it work? Well, it depends on what period you look at, but over the last five years in return for a fee of 0.43%, cheaper than an active fund but more than some passive ETFs I have to say, in return for paying that 0.43%, it's up on average 1.8% per annum over the last five years; more than the S&P 500.

So, you've probably done a little shy of 2% better on average per year for the last five years from being here than there but that is just the last five years I should stress.

There are people around, in summary, who say, "Well, fund management used to be about offering you active or passive fund management cheap. It doesn't always give you the best returns, expensive doesn't always give you the best returns either."

So, smart beta is a little bit of jargon. I have something to do with it, a little bit of jargon saying that actually we can do this with a twist. We can do this but be a bit more clever about the stock selection.

My one caveat would be this: if you are a fan of pure passive investing index following and there are plenty of people out there who quite like that idea, be aware that you will obviously pay more for smart beta than plain old vanilla beta. But, in fairness that tends to be the way life goes in fund management.