Investors seeking low-cost investment strategies with well-defined outcomes are flocking to smart beta exchange-traded funds (ETFs), which could account for one-third of all ETFs listed on the Australian Securities Exchange (ASX) by the end of 2018.

The Australian ETF market enjoyed record growth last year. As at 31 December 2017, the market capitalisation of the 175 exchange-traded products (ETPs) listed on the ASX had jumped 39 per cent to $35.7 billion compared to 12 months earlier, according to ASX data.

ETP flows were the highest on record in 2017 at $7.9 billion. ETFs make up 92 per cent of total ETPs by market capitalisation.

Globally, smart beta is the fastest growing segment of the investment management industry, with over 1,200 products listed with US$592 billion of funds invested in smart beta ETFs.

In Australia, almost one in three ETFs listed on the ASX is now smart beta. That growth will likely continue this year as more investors turn to smart beta ETFs for the first time, seeking low-cost targeted investment outcomes.

Increasingly, first time investors are buying ETFs--and smart beta ETFs--rather than direct shares or managed funds given the cost-effectiveness with which they can be bought on ASX. We expect the Australian ETF market to be valued at between $70 billion to $80 billion within five years given the momentum of inflows.

Defining smart beta

Smart beta ETFs give Australian investors access to transparent rules-based investment strategies for building wealth. They combine the best aspects of active and passive management by tracking indices that are designed to deliver targeted investment outcomes.

Popular smart beta strategies include equal weighting or factor-based strategies which may, for example, target quality and value. Factor-based investing has long been a part of institutional investors' portfolios and academics have backed its investment benefits through numerous studies.

Now, the ever-innovating ETF industry is making factor-based investing accessible to retail investors through smart beta ETFs. In addition to providing retail investors with access to institutional strategies, smart beta ETFs also provide access to assets classes previously thought to be difficult and expensive to access.

For example, retail investors can now simply access by a single trade on ASX, a portfolio of quality international shares as offered by the VanEck Vectors MSCI ex Australia Quality ETF (ASX: QUAL), or attractively priced US companies with sustainable competitive advantages, as offered by the VanEck Vectors Morningstar Wide Moat ETF (ASX: MOAT).

In Australia, we expect more flows to Australian equal weight ETFs. Equal weight investing represents a way in which investors can diversify risk in their portfolios by being broadly invested in different companies rather than concentrated in a handful of large companies.

Equal weighting has been around since the 1970s. To better understand its dynamics, many institutions such as The University of London's Cass Business School, EDHEC Business School, Goethe University, and Australia's own Monash University have investigated and demonstrated the long-term risk-adjusted outperformance of equal weight investing.

Among the reasons academics cite an equally weighted portfolio as having superior investment outcomes are its:

1) higher exposure to smaller stocks rather than to bigger stocks; and
2) contrarian trading strategy.

These findings reinforce industry research by index companies S&P Dow Jones Indices and MVIS.

This is important research for Australian investors. The dominance of the big banks and miners in the S&P/ASX 200 Index has consistently created biases in the Australian equity market.

The chart below shows that the financial and materials (mining) sectors dominate the Australian share market--and they have for some time.

S&P/ASX 200 sector breakdown

Source: Factset, VanEck; data from 2000 to December 2017

Equal weight investing can remedy this overexposure to the financial sector. The MVIS Australia Equal Weight Index selects only the largest and most liquid securities on the ASX, currently 81, and equally weights them at each rebalance.

Currently, the MVIS Australia Equal Weight Index has only 19.4 per cent exposure to the financials sector, which alone represents 35.6 per cent of the S&P/ASX 200 Index.

The equal weight experience in Australia matches the research which suggests it will outperform. The MVIS Australia Equal Weight Index has outperformed the S&P/ASX 200 Index in 12 out of the last 15 years to the end of 2017.

Reflecting high levels of satisfaction with smart beta ETFs, VanEck's second annual smart beta survey recently found 99 per cent of financial professionals using smart beta in 2017 are "moderately, very, or extremely satisfied".

At least 50 per cent of Australian financial professionals are now using smart beta strategies in portfolios, up from 37 per cent in 2016. This popularity is spreading to retail investors.

Outperformance is the biggest attraction, followed by lower costs compared to actively managed funds. These are important factors which are driving the growth of the ETF market in Australia and the uptake of smart beta ETFs.

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Arian Neiron is the managing director and head of Asia Pacific at VanEck, 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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