Smart beta: The clever way to invest for retirement?

Tom Selby analyses the move away from market cap-weighted indices to alternative strategies

The dynamics of the retirement market have shifted beyond all recognition since the introduction of pension freedom.

Furthermore, rising life expectancy means savers are leaving their money invested in the stock market for longer, desperate to squeeze as much income and capital growth out of their pots as possible.

Advisers and clients looking to invest in risky assets have traditionally paid a fund manager to do it on their
behalf, or used cheap tracker products in a bid to minimise costs. Most will use a combination of the two.

Some now believe smart beta, the latest American idea to hit the UK, could revolutionise the way people invest money by bringing active performance at a fraction of the cost.

But others argue it is simply another fad designed to boost the margins of exchange-traded fund (ETF) managers feeling the pinch from price competition.

Halfway house

Traditional tracker funds are often criticised because they can leave investors exposed to the fortunes of one particular company or sector. This is because asset allocation tends to be based on the market capitalisation of the firms within the index, meaning retirement investors could end up holding large chunks of their portfolio in a single sector or company.

Smart beta attempts to overcome this market-cap bias by using a range of factors, depending on the investor’s preference, to determine how much of each asset in a particular index the fund should hold.

Some smart beta products will swap the market-cap approach for equal weighting, so no single stock in an index has undue influence on the performance of the fund as a whole.

Others will use screening tools so asset allocation is based on one or more other factors, such as value, momentum, dividends, volatility and so on.

As a general rule, the more of these factor screens a fund applies, the closer it will resemble an active fund and, unsurprisingly, the higher the price.

1216 smart beta table

The evidence

Growth in passive investing has been phenomenal in recent years. Assets in US ETFs have passed the $2trn mark, with more than 1,400 funds offered to investors.

According to Morningstar, assets under management in European exchange-traded products more than doubled between 2009 and 2014, reaching $362bn back in September 2014.

Smart beta has been one of the fastest-growing segments of the US ETF market, rising from nothing at the turn of the millennium to about $200bn in assets at the end of 2014, according to Bloomberg Intelligence.

However, the jury is still out on whether these factor-based, halfway house strategies really deliver better risk-adjusted returns than their passive and active counterparts.

In his 2015 study How Smart are ‘Smart Beta’ ETFs, Denys Glushkov of the University of Pennsylvania analysed the performance of 164 US equity smart beta ETFs between 2003 and 2014.

While the paper found that 60% of smart beta fund categories had beaten their raw passive benchmarks, Glushkov concluded: “I find no concrete empirical evidence to support the hypothesis that [smart beta] ETFs outperform their risk-adjusted benchmarks over the studied period.”

Others have highlighted concerns about performance claims based on back testing. This is open to manipulation as firms can build factors into a product to ensure it would have done well based on historic market performance.

In addition, it is worth noting the average cost of smart beta funds was also 70% higher than traditional cap-weighted ETFs (0.41% vs 0.24%), according to Glushkov’s study.

Tool in the armoury

So can smart beta help solve the retirement income conundrum in a debt-laden world where yield remains hard to come by?

The extra choice provided by smart beta strategies – sitting as they do somewhere between active and passive management – makes them a useful tool in the advisers’ armoury. However, you need to be aware of both the potential risks and benefits before investing.

Smart beta allows investors to deviate from the asset allocation of a particular index. By doing this, it is likely the portfolio will also perform differently to that index.

By focusing in on a specific style, investors have the chance of outperforming the traditional index if this style performs well. But the flip side is that you can significantly underperform the traditional index if the style falls out of favour.

It is also worth remembering that smart beta strategies are more expensive than traditional passive strategies and investors will need to determine whether this additional cost is worth paying. When investors flock to a particular factor – volatility being an obvious one today – the price will inevitably leap as a result.

In addition, in times of turmoil, investors might find that liquidity in these products is not what they hoped for, particularly if they are looking at small strategies from newer entrants in the market.

This, coupled with the lack of reliable performance data, will likely mean many advisers and clients prefer to keep a watching brief on the smart beta market – at least for now.

Tom Selby is senior analyst at AJ Bell