Smart beta ETFs

Smart beta is the next evolution of investing. Sometimes it is referred to as 'strategic beta', 'alternative beta' and 'quantamental indexing'.

Smart beta is the term given to ETFs (Exchange Traded Funds) which track an index that differs from the traditional market capitalisation approach of selecting shares, bonds or other assets. That is, smart beta ETFs take a “smarter” and more considered approach to what goes into the fund other than just the size of the company.

The smarter approach may be based on one or more predetermined factors or investment methodologies.

Smart beta is a type of investment that combines the benefits of passively managed funds, such as lower costs, with the advantage of selecting investments based on certain formula-based rules, adding an active element. Smart beta strategies differ from actively managed funds, where a manager chooses individual stocks or sectors to target an outcome. Instead, smart beta ETFs track an index with rules, but there is little or no human element.

We like to say smart beta combines the best of active and passive investing: having the potential for better investment outcomes while being rules-based, transparent and cost-efficient.

Institutional investors have been using smart beta for years. It is now becoming more widely used and accepted by all types of investors.

Let’s start with ‘beta’. It’s the second letter of the Greek alphabet. In financial jargon, the performance of the market as a whole is called “beta”. Often the sharemarket indices quoted in the press are considered the market’s beta. Often these are, what is called, ‘market capitalisation’ indices. For example, it is common for the Australian media to report the Australian sharemarket’s return as represented by the S&P/ASX 200. The S&P/ASX 200 contains the 200 largest listed companies in Australia by their size (market capitalisation). This is similar to the US’s S&P 500, the UK’s FTSE 100 and China’s CSI 300.

To understand where smart beta has evolved from, it may be useful to understand some of the advances of indexing and investing. So, back to beta.

When Charles Dow first published the Dow Jones in 1896, he allocated weightings to the top 12 stocks of the day based on their prices.

The Dow Jones is still widely quoted today. Let’s look at how it is constructed. It is a price-weighted index, which means that the stocks with the highest price have the largest weighting. So a company with the highest share price, has the highest weighting in the portfolio. While the Dow Jones provides a general barometer of US equity performance, it does not make any sense from an investment perspective because a high share price could be a function of having less (or more) shares on issue.

As a result, the next index innovation was ‘market capitalisation’, which was pioneered by Henry Varnum Poor and the Standard Statistics Co. The result was the 1926 predecessor of the United States’ S&P 500. A market capitalisation index uses the size of a company for inclusion (the share price multiplied by the number of shares on issue). Therefore, in a market capitalisation index, the larger companies have bigger weights.

Market capitalisation indices were considered better barometers of the market. Again though, the initial intention of the index is to be a market barometer, not a tool for investment. As a tool for investment, market capitalisation was supported by research in the 1950s. This is the Theory of Efficient Markets.

The Theory of Efficient Markets or The Efficient Market Hypothesis is that the price of each stock in the market reflects all the relevant information about that stock and thus the market trades at fair value. That is, the current share price is the best, unbiased share price estimate. Based on this theory, market capitalisation-weighted indices must deliver the best returns for the least risk. There has been significant academic and commercial literature in support of the efficient market hypothesis. It was thought that you cannot outperform the market unless you take on additional risk.

But there are numerous examples where the market has been wrong. There have been periods of irrational buying and selling and periods during which bubbles have formed. Consider too, the differing needs of individual investors and institutions. Each has a unique reason for buying and selling shares and thus each assigns a different value to different aspects of the financial transaction which is often unrelated to the valuation. Investors sometimes trade for liquidity, tax, income or even emotional reasons which further distorts market prices. As a result of these factors, the reality is that the market is not efficient.

By the 1970s professional fund managers were aiming to exploit these inefficiencies, targeting returns above market capitalisation indices. This is “active management”.

When actively managed funds were first offered to investors, performance was uncertain, and the costs were high. Sometimes the returns were good, but often they weren’t. Many people found this a poor bargain and moved to lower-cost passive funds which tracked traditional indices. In these new funds returns could be thought of as average - not high, not low, just the market average. The rise of ETFs this century has largely been driven by demand for these passive funds.

Initially, these passive funds tracked market capitalisation indices. However, sophisticated investors in passive funds started to consider the possibility that alternate index weightings could give investors higher returns for the same, or even lower levels of risk. In response, index providers started to create indices that used a method different to market capitalisation. Alternate index construction methods started to focus on factors and fundamentals to screen or weight stocks, including equal weighting constituents.

These innovative index construction techniques became known as “smart beta”.

*Source: S&P Dow Jones Indices SPIVA Australian Scorecard Mid Year 2023

Comparing indices (betas)

When you are selecting which ETF to invest in, the most important feature to assess is the index the ETF tracks. While the fees, and the expertise of the issuer are also important, these considerations should only be assessed once investors fully understand the index the ETF tracks, be it market capitalisation or a smart beta index.

There are four critical questions that investors must ask to assess an index:

• Does the index match your investment objectives? Generally, the higher the risk you take with your capital, the higher the return you expect to reap over time. Your ETF investment, and therefore the index it tracks, should match your risk profile and the outcome you are trying to achieve. Investors need to examine whether the purpose of an index, such as exposure to an equity or bond market, meets the investor’s own investment objectives and risk profile.
• Is the index concept supported by research and experience or is it a fad? Index design should be supported by reputable research and have historical data from a reputable index provider through an economic cycle.
• Is the index easy to understand? Can you explain the index to someone else? If you can’t, do you really understand what investment the ETF is offering? The more complex it is, the more uncertain the risks and investment outcome are likely to be.
• Does the index perform as you would have expected? The index’s historical data should be readily available so you can easily assess the past performance of the index to determine if it does what it claims to do, in other words, if it is true to label. Always remembering that past performance is not indicative of future performance.

Let’s now use this framework to assess two Australian equity indices.

Assessing the S&P/ASX 200 Index

Let’s assume that you are assessing an ETF that tracks the standard Australian stock market benchmark index, the market capitalisation weighted S&P/ASX 200 Index.

• Does the index match your investment objectives?

  Exposure to a diversified portfolio of Australian equities will potentially help you achieve growth over the long term. The S&P/ASX 200 captures one version of the returns of the Australian share market, namely the top 200 companies included proportionately based on their market capitalisation. However, if you are also seeking diversification, the S&P/ASX 200 exposes investors to concentration risk. The top 10 companies represent nearly 50% of the index. Five of these companies are banks. Financials make up about two thirds of the index. Such concentration is problematic if bubbles form. Sector and stock concentration make sense if an investor is ‘bullish’ or confident the sector or stock will outperform, but investors buying a fund that ostensibly contains 200 stocks would likely assume such a broad-based fund to be much better diversified.

• Is the index concept supported by academic research and experience or is it a fad?

  No, it’s not a fad. Market capitalisation weighting has been the dominant index weighting method for many years. Investing in market capitalisation indices has historically been supported by the theory of the Efficient Market Hypothesis (EMH) which was developed in 1970 by economist Eugene Fama. EMH asserts that market prices should only react to new information or changes in discount rates therefore stocks always trade at their fair value, making it impossible at any time for investors to either buy undervalued stocks or sell stocks for overinflated prices. Proponents of EMH believe, it is impossible to outperform the market through stock selection or market timing and the only way an investor can possibly obtain higher returns is by luck or by investing in riskier investments. Unsurprisingly there has been legitimate criticisms of EMH by investors, including Warren Buffett who has persistently beaten the market, and behavioural economists including Nobel Prize winner Daniel Kahneman.

• Is the index easy to understand?

  Yes. The S&P/ASX 200 is quoted in the media and is the standard Australian benchmark index. Most investors understand that in a market capitalisation index, a company’s weight is determined by its size.

• Does the index perform as you would have expected? Is it true to label?

  Yes. If the media reports the Australian share market rose 2% it’s likely the S&P/ASX 200 rose 2%. With a market capitalisation index such as the S&P/ASX 200, the largest companies have the biggest impact on its performance. Therefore, if Australian banks do well, so too will the S&P/ASX 200. Because of this skew towards large companies’ returns, the S&P/ASX 200 doesn’t track the overall share market as well as it tracks the performance of large, listed companies. This reflects the fact that market capitalisation indices were originally designed to measure the health of the market and not with investment objectives in mind.

Assessing the MVIS Australia Equal Weight Index

Let’s assume that you are assessing an ETF that tracks the MVIS Australia Equal Weight Index, which equally weights the largest and most liquid stocks on the ASX.

• Does the index match your investment objectives?

  Exposure to a diversified portfolio of Australian equities will potentially help you achieve growth over the long term. The MVIS Australia Equal Weight Index currently includes 79 Australian companies. The Equal Weight Index, as the name suggests, gives each stock in the index an equal weighting, so a mega-cap company has an equal weighting to a large- or mid-cap company. This equal weighting strategy gives the index greater diversification than the S&P/ASX 200 Index. In fact, research shows that the Equal Weight Index is three times better diversified than the S&P/ASX 200¹.

  The Equal Weight Index reduces stock and sector concentration risk by diversifying away from financials and large resources, which dominate the S&P/ASX 200, and broadening into the other sectors of the market such as consumer discretionary and industrials.

• Is the index concept supported by academic research and experience or is it a fad?

  Yes. It is not a fad. Equal weighting is a strategy that has been around since the 1970s and has taken off in the US and Europe in the 1990s and now in Australia, with many academic institutions such as The University of London’s Cass Business School, EDHEC Business School, Goethe University and Australia’s own Monash University, demonstrating the long-term outperformance of equal weight investing. These findings reinforce industry research by index companies S&P Dow Jones Indices and MV Index Solutions. The experience in Australia has also matched the research, where the Equal Weight Index has outperformed the S&P/ASX 200 Index in 11 out of the last 14 years.

• Is the index easy to understand?

  Yes. In fact, it’s arguably as easy as it gets. An equal-weight index simply applies the same weighting to all stocks to be included in the index.

• Does the index perform as you would have expected? Is it true to label?

  Yes. The MVIS Australia Equal Weight Index enhances diversification and is true to the label. It has different returns than the S&P/ASX 200 Index. You can see its performance here.

  Relative to the S&P/ASX 200, the equal weight index tends to outperform when large companies do poorly, and it tends to underperform if Australia’s big banks or big miners outperform. It’s important to remember that past performance is not indicative of future performance. 

  Discover more about smart beta investing with our latest insights about smart beta ETFs. 

Explore our ninth-year VanEck’s Smart Beta Survey results among Australian financial professionals.