Smart beta: The new disruptive innovation
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"Smart" or strategic-beta strategies have recently moved from the periphery into the mainstream investment industry and have the potential to significantly disrupt traditional active management.
Disruptive innovation is a management framework introduced by Harvard professor Clayton Christensen to describe a market or value network that eventually disrupts an existing market or value network.
The book, The Innovators Dilemma, catapulted Christensen to superstar status in tech-savvy Silicon Valley in the 1990s.
Decades on, disruptive innovation has been used to coin a number of recent innovations such as Netflix.
The investment industry is susceptible to disruptive innovation as established players continue to enjoy profit growth and are protected by barriers to entry.
The need for superior money management has never been greater, with total investable assets continuously rising. Active management in particular is not left unscathed.
The widely regarded CFA Institute has classified smart beta as a disruptive innovation with the potential to significantly disrupt traditional active management.
What is smart beta?
Smart beta could be thought of as the intersection between active and passive management, aiming to outperform traditional benchmark indices while offering the benefits of passive management including being rules-based, as well as having low costs and transparency.
Smart-beta strategies are not especially new and can be traced back to the 1970s, but have recently moved from the periphery into the mainstream investment industry due to the growth of exchange-traded funds that track smart-beta strategies.
Smart-beta strategies enable investors to achieve targeted investment by actively identifying a factor or investment approach they want in their portfolio, while enjoying index-like features.
There are different types of smart-beta strategies, some of which are outlined below:
All constituents are given an equal weighting regardless of their market capitalisation.
Components of equal weight indices are often selected from a universe of stocks based on market capitalisation before being equally weighted.
Equal weighting may be applied at the individual stock or sector level.
All securities are based on factors such as quality, dividends, momentum, low volatility or a combination of these.
Combinations may be weighted by factors or by market capitalisation or a combination of these.
Components of factor-based indices are often selected from a universe of stocks based on market capitalisation before screening is applied.
Individual stocks cannot exceed a maximum percentage of the index.
Components of capped-weight indices are often selected from a universe of stocks based on market capitalisation before the capping is applied.
The proportion of each constituent is based on the company's value using economic and accounting fundamental factors instead of price.
Fundamental factors include total assets, sales, cash flows, numbers of employees or a combination of these and other factors.
Some indices use a combination of smart-beta strategies, such as the Morningstar Wide Moat Focus Index, which equally weights the most attractively priced US companies that have passed Morningstar's proprietary Wide Moat screen.
Smart-beta ETFs are at the forefront of smart-beta investing, combining the best aspects of active and passive management by tracking indices that deliver a chosen investment outcome, while retaining transparency, liquidity and ease of trading within defined rules.
ETFs that track smart-beta indices do so by holding the shares that are in the index and only changing their portfolio when the index changes.
Traditionally, most ETFs followed conventional market-capitalisation-weighted indices. However, this trend is rapidly changing with smart-beta ETFs emerging as an option offering a desired portfolio outcome.
Smart beta: An Australian equity case study
The Australian equity market is one of the most concentrated equity markets in the developed world.
The standard benchmark, the S&P/ASX 200, is a market-capitalisation-based benchmark. It is often the benchmark active investment managers are measured against and is also used as a passive investment strategy benchmark.
The problem with the S&P/ASX 200 is that the top 10 companies comprise over 55 per cent of the index, of which four are the big banks. It is concentrated not only in stocks, but also in the financial sector.
This is not an ideal investment strategy if you were aiming to diversify and have broad exposure to the various sectors that make up the Australian economy.
To help address the issue of concentration risk and offer a proven passive investment strategy, a smart-beta index using an equal weighting methodology called the MVIS Australia Equal Weight Index was introduced.
The result is a portfolio of 78 securities which are equally weighted so that no one company dominates the portfolio.
Equally weighting the portfolio enables outperformance because of three key factors:
• Higher exposure to smaller stocks rather than to bigger stocks;
• Higher exposure to undervalued stocks and lower exposure to overvalued stocks; and
• Contra trading, that is, better market timing, meaning better returns when markets are rising and less losses when markets are falling.
The VanEck Australian Equal Weight ETF (ASX: MVW) tracks the MVIS Australia Equal Weight Index. MVW is an example of a smart-beta ETF that offers investors a cost-effective, transparent, rules-based strategy.
Over the past 12 months, the MVIS Australia Equal Weight Index has outperformed the S&P/ASX 200 Accumulation Index by over 9 per cent.
It has consistently outperformed the S&P/ASX 200 Accumulation Index over each of the past three, six and 12-month periods and in 11 of the last 13 calendar years.
Smart beta investing on the rise
Smart beta is revolutionising the way investors build portfolios. Globally, smart beta is the fastest-growing segment of the investment management industry and Australia is also experiencing this trend.
The CFA Institute recently reported that smart-beta products--by carving out a significant component of active man¬agement and offering it more cheaply and more transparently--will disrupt the business of active management.
In particular, "active management will evolve into two separate product types: smart-beta products with lower fees and pure alpha products with higher fees".
Arian Neiron is the managing director of VanEck Australia. Established in 1955, VanEck is one of the world's largest ETF providers. This is a financial news article to be used for non-commercial purposes and is not intended to provide financial advice of any kind.
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