WisdomTree: Why not all smart beta ETFs are created equal

Press Release | Wisdom Tree

Smart beta is not a single strategy but a range of custom-made options for investors to pick from and so, says Nizam Hamid, transparency and education are paramount in identifying the right approaches

Exchange-traded funds (ETFs) are gaining a momentum in Europe that shows few signs of slowing any time soon. Not the least in this is the smart beta sector, which according to Morningstar represented around a fifth of the $4.1 trillion (£3.2 trillion) global ETF market at 31 July 2017. Despite smart beta’s growing popularity, however, the nuances present within the different strategies warrant a closer look.

First, smart beta is not a single strategy but an all-encompassing term to describe a multitude of strategies ranging from simple to complex.
Second, smart beta strategies are rules-based – in other words, they aim to achieve better risk-adjusted returns in a systematic way. The difference between smart beta funds are the ways in which each fund selects and weights specific securities or investment objectives.
Some of the smart beta strategies that are attracting attention are listed in the table below. A range of products are offered within each of these categories, ranging from those weighted by a single factor, such as dividends or value, say, to those skewed towards multiple factors within a single ETF.

Table 1: The range of smart beta strategies
*Smart beta strategy*	*Description*
Fundamentally weighted indices	Components are selected to provide broad exposure to an equity market, but companies are weighted by a fundamental factor, such as aggregate dividends or earnings, rather than market capitalisation.
Equal-weighted indices	Components are based on established indices like the S&P 500, but are equally weighted so that all components have identical weights when rebalanced.
Factor-based indices	Components are selected and weighted, based on one or more fundamental factors.
Low-volatility indices	Components are selected because they have exhibited lower volatility than the overall stock market and/or are weighted based on their historic volatility.

Some investors believe smart beta strategies have only performed well because money has flowed into them. In other words, investor enthusiasm would have driven returns by bidding up valuations.
We find this unlikely, however, given the short history of smart beta and the relatively small scale of investment. In fact, this may be applicable to more traditional market capitalisation-weighted indices that assign more weight to a stock as its price rises.
This contrasts with a smart beta strategy such as, say, weighting companies by their annual cash dividends, which can offer a highly objective measure of a company’s health, value and balance-sheet strength.

Different Strokes

Ultimately, transparency and education are the key to the future success of smart beta ETFs. Investors therefore need to take a closer look at providers’ smart beta strategies – the approach, what it invests in, whether it complements what they already own and what type of exposure it gives.
It can certainly be challenging to distinguish all that is out there. When it comes to identifying truly smart beta strategies, investors and their advisers should seek out the following:
* A rules-based, repeatable methodology that offers broad, representative exposure to an asset class.
* Alternative weighting methods that allow for ample investment capacity.
* High correlations to established benchmarks.
* An established track record on a total return and risk-adjusted basis.
* Regular rebalancing.