Investors should always ‘look under the hood’ of an Exchange Traded Fund (ETF) before considering investment. Determining what assets a particular fund may hold can be as simple as looking at its name, or even its ticker! But what is typically less obvious is the method used to determine how much weight is given to each holding within a fund.
At the date of writing, there are 292 ETFs trading on the ASX, spanning a wide range of asset classes and markets. However, each of these funds can be more broadly categorised into one of three investment strategies, which determines how much of each asset is held in the fund (its weighting): traditional passive, Smart Beta, and active.
The evolution of passive investing and Smart Beta
Passive investing revolutionised the investment management industry, which up until its advent, had been dominated by active fund managers who would generally employ market timing or security selection strategies aimed at outperforming the ‘market’. The introduction of traditional passive funds allowed investors to receive ‘market’ exposure, which was ultimately what most portfolios were benchmarked against, at a fraction of the cost of active funds.
Passive funds aim to track the performance of an index. However, most traditional indices, such as the S&P/ASX 200 Index or the MSCI World Index, are designed to weight their securities according to their market capitalisation, which is a function of both a security’s price and the number of securities on issue.
Traditional passive funds, therefore, increase their allocation to securities that have risen in price and reduce the weight for securities that have fallen in price. Herein lies the source of several limitations of traditional passive funds. The dot-com crash in the early 2000s brought a number of these limitations to the surface. Just prior to the crash, many traditional market indices were heavily concentrated in high-flying growth companies trading at lofty valuations.
As a result, investors in traditional passive funds suffered large losses when prices aggressively reversed to reflect their ‘true’ or fundamental value more closely.
Enter Smart Beta
Despite the flashy name, Smart Beta is simply any passive investment strategy that uses some measure other than market capitalisation to determine weightings in a portfolio.
By breaking the link between the price of a security and its portfolio weight, a Smart Beta approach seeks to overcome the pitfalls of traditional indices while retaining most of the advantages of passive investing. The table below compares Smart Beta strategies against traditional passive and active strategies.
The ‘Smart’ benefits
By design, Smart Beta strategies aim to provide investors with excess returns, relative to traditional market cap-weighted indices.
Given portfolio weights are anchored to a measure other than price, most Smart Beta funds will engage in value-based trading at the time of rebalancing. That is, generally, the fund will sell securities that have risen in price relative to their ‘true’ value, or intended weight in the portfolio, and buy securities that have fallen in price.
While Smart Beta strategies offer the potential for excess returns in the long term, investors should also be aware that they may underperform traditional indices periodically. This is especially true during momentum-driven markets where prices are trending higher.
Another common issue amongst traditional indices is that they are prone to large and disproportionate concentrations, across both sectors and individual names. For instance, as at the end of May 2022, the Materials and Financial sectors in Australia accounted for over half of the S&P/ASX 200 Index, while BHP on its own represented 11%.
Again, by anchoring portfolio weights to a non-price measure, Smart Beta funds generally seek to provide investors with greater control in relation to their risk exposures and greater diversification.
Examples of Smart Beta in action
There are various types of Smart Beta ETFs available on the market today. These include:
Factor weighted –which involves targeting securities with common properties that are expected to provide superior performance characteristics over time. An example of a factor weighted fund is the BetaShares Australian Quality ETF (AQLT), which weights Australian companies according to their Quality score across metrics such as return on equity, debt to equity, and earnings stability.
Fundamental weighted – which seeks to weight securities according to their true fundamental value by using accounting measures. An example of a fundamental-weighted fund is the BetaShares FTSE RAFI Australia 200 ETF (QOZ), which uses four fundamental measures in determining the weight of its holdings – revenue, cash flow, dividends, and book value.
Equal weighted – which, as the name suggests, involves giving each portfolio security the same weight. Equal weighted funds effectively reduce portfolio concentration within large-cap companies and provide a size-tilt towards smaller companies in the portfolio. An example of an equal-weighted fund is the BetaShares S&P 500 Equal Weight ETF (QUS), which equally weights the largest 500 companies in the US – a market that is particularly concentrated across a handful of large technology names.
Where Smart Beta may fit within an investor’s portfolio
When used effectively, Smart Beta products may help to improve portfolio outcomes. As illustrated below, Smart Beta strategies such as the FTSE RAFI Australia 200 Index, which the BetaShares QOZ ETF aims to track, has delivered higher risk adjusted returns over the long-term, relative to the Solactive Australia 200 Index, a traditional passive strategy that the BetaShares A200 ETF aims to track.
There are also potential benefits of combining a traditional low cost passive ETF, like A200, together with a Smart Beta product, like QOZ. To illustrate, the table and chart below show the hypothetical performance of the combined A200/QOZ indices based on a 50/50 split (after deducting applicable ETF management costs), has delivered similar risk adjusted returns with lower tracking error and lower fees, as compared to QOZ’s index (after management costs) on a standalone basis. This may prove a useful strategy for investors who are concerned about any periods of Smart Beta underperformance and tracking differences, relative to the broader market.
*As at 31st May 2022.
Source: Bloomberg, BetaShares Capital. You cannot invest directly in an index. Past performance is not indicative of future performance of any index or ETF.
1. Common Index Inception Date for the performance comparison period is 17th September 2010. This is not the inception date of either A200 or QOZ, which were launched in 2018 and 2013 respectively.
2. Shows the performance of the Solactive Australia 200 Index, which A200 aims to track, after taking into account management costs of 0.07% p.a., and not the actual performance of A200. Inception date of A200 is 7 May 2018.
3. Shows the performance of the FTSE RAFI Australia 200 Index, which QOZ aims to track, after taking into account management costs of 0.40% p.a., and not the actual performance of QOZ. Inception date of QOZ is 10 July 2013.
4. Shows the combined performance of A200’s index and QOZ’s index, assuming a portfolio comprised of a 50:50 allocation between A200’s index and QOZ’s Index, after deducting average management costs of 0.24% p.a., rebalanced quarterly.
5. Calculation of Sharpe Ratios assumes an average risk-free rate of 1.8%.
6. Tracking error relative to the Solactive Australia 200 Index.
7. Average Management Costs for combined A200’s index with QOZ’s index is an estimate only, assuming a constant 50:50 split holding of A200 and QOZ.
Please note that the above illustration is not a recommendation to adopt any particular investment strategy and does not take into account any potential investor’s particular circumstances or tolerance for risk. No assurance can be given that a Smart Beta methodology will outperform a traditional market-cap weighted methodology over any time period.