By David Stevenson –

Smart beta is a term that seems to have suddenly emerged out of nowhere to describe the rise of a new form of ‘passive’ investing. The very words themselves conjure up a certain egg-headed technical prowess, implying that all the other beta trackers out there are just “back of the class” dullards, market capitalisation based, one-trick ponies that don’t do all the clever stuff that smart beta trackers can accomplish with their quantitative prowess.

David Stevenson, columnist at ETF Strategy.

Scratch beneath the surface though and we discover a slightly more honest admission by the ETF industry, which is that the sector has been ever so slightly struggling to defend itself against a very powerful criticism from its active peers. They concede that trackers are cheaper, but they ask whether investors really want to be putting their money into funds that blindly buy EVERY company in a major index.

A year ago, for instance, how many of us would have been comfortable with the fact that a typical S&P 500 tracker had a very large chunk of Apple, sans Steve Jobs? Or what about all those huge Russian companies that have suddenly made an appearance in the FTSE 100 index? Does that feel right to you? It’s a priceless pitch of course by the active lobby, followed up quickly by an incessant call to invest in “our actively managed fund where we control risk” – you know the rest by now!

Unfortunately, the very best answer to this from the passive brigade hasn’t sounded quite so clever over the last few years. This response goes something along the lines of “why worry about these ‘short-term’ variations because the market will over time sensibly adjust”!

And that’s a good defence if you have investor with ten or even twenty-year time frames, who can probably safely ignore all this noise about companies with a disproportionate share of an index, safe in the knowledge that what really matters is (a) to keep costs down and (b) not to make too many active stockpicking and market timing mistakes.

But sadly this ignores the fact that a vast number of investors don’t actually have a 10 or even 20-year time horizon. Many more have become naively tactical, worried that the great QE-inspired monetary revolution will come to a sticky end. So talk of being patient has largely fallen on deaf ears.

Smart beta addresses this criticism head on and offers up any number of clever ‘work arounds’ including the use of fundamental indices to minimise exposures, dividend weighting to dampen down equity volatility and volatility controls to weed out excitable and dangerous stocks. On balance I think this smart beta revolution is to be applauded and should give the sector a very effective counter to all those Russian/Apple jibes – “well, our smart beta tracker doesn’t buy all those ever so slightly worrisome stocks in the main index, we filter them out!”

The key, though, is to understand that all this filtering and smart use of quantification is actually an exercise in risk mitigation. It isn’t really about anything other than explaining to a committee of pension fund trustees how you’ll control downside risk. You can hear the investment consultant pitch now – “well dear trustees, we’ve decided to fire that expensive active manager we used to employ! We’ve cut costs and made life easier but we’re going to use these clever smart beta funds to minimise our downside risk. It also means we won’t have answer any awkward questions from our pensioners about why their money is in some dodgy Russian mining company”. Hurrah, hurrah… Triples all round!

But this laudable exercise in risk mitigation isn’t quite as simple as it sounds.

Let’s take each of the risk mitigation strategies in turn.

First, the most obvious, which is low volatility or minimum variance as practised by the likes of Ossiam and iShares.

It’s an idea that I heartily approve of, BUT it can leave the investor open to a very specific risk, which is that of sector concentration. Put simply low-vol indices, such as the S&P 500 Low Volatility Index, tend to have a higher concentration of either defensive sectors such as consumer staples and utilities. There’s nothing intrinsically wrong with that, and in fact a recent paper by Andrew Lapthorne at Societe Generale (SG) reminds us that consumer goods stocks are actually much less likely to fall in value sharply during a market downturn. If you’re happy with that, great, but what happens when equity markets adaptively evolve and those defensives suddenly become far too expensive? I’d also be very keen to know how these indices actually react in times of extreme market distress – will the low-vol trackers really suppress market turbulence? I think the answer will be a resounding yes, but we need to see these ETFs actually deliver on the promise. In the meantime maybe investors might also want to look at good old fashioned consumer staples and utilities sector ETFs.

Dividend-focused ETFs have also emerged as a major force to reckon with, and again it’s hard to disagree with the idea behind funds such as the SSgA’s SPDR S&P UK Dividend Aristocrats UCITS ETF (UKDV) (which I own). Evidence shows us that the flow of dividend payouts is actually much less volatile than equities. It’s also true that those companies that progressively increase their dividends tend to have even less volatility in total returns terms. But dividends can also become heavily concentrated in certain sectors and I worry that in a severe market downturn, a spate of cancelled dividend payouts by leading companies might spark carnage in the equity income sector.

Fundamental indices such as the recently launched First Trust United Kingdom AlphaDEX UCITS ETF (FKU) try another tack, which is to use a series of fundamental scoring systems to filter through the market. It’s not a new idea and in fact Rob Arnott’s RAFI Indices have been at this game for quite some time with varying levels of success – I’ve always had a soft spot for the Invesco PowerShares FTSE RAFI UK 100 ETF (PSRU).

Again I applaud the idea of fund trackers but I have my small concerns. Just how black box is the index construction? What do we know about the exact mix of fundamental factors and how that changes over time? Is the ‘system’ really just a form of value investing? Will value investing really work in the future?

I think the answer to nearly all these questions is a positive, but I reckon the real trick is to know which ‘system’ is the best one i.e. understanding the magic sauce that goes into each fundamental scoring system and working out which is best. On that basis my favourite fundamental index has to be the SG Quality Income Strategy Index (SGQI) developed by Andrew Lapthorne at SG, see the Lyxor ETF SG Quality Income (SGQU). Again, for full disclosure, I have this tracker in my portfolio.

Andrew has been banging on about his ideas for a decade now and you can read about the ideas ad infinitum online, in his research notes (which are fairly easily downloaded) and via media commentators like yours truly or Merryn Somerset Webb over at Money Week – the SGQI is very far from being a black box structure.

In particular I like the fact that Andrew doesn’t focus on just one or two factors such as the level of the dividend yield or the volatility of the stock. Crucially, he looks at the quality of balance sheets as well as the income stream of dividends i.e. quality companies that pay a good dividend.

Personally I’d like there to be more competitors to Andrew’s fund in ETF land, giving us all a bit more choice. In my ideal world I’d quite like an index which combined all of the following…

– Companies with long-established progressive dividends policies
– Companies with sound balance sheets
– Relatively low levels of volatility
– Global diversification

In the absence of a single European-listed ETF that resolutely ticks all the boxes, I’d probably suggest a mini smart beta portfolio consisting of an AlphaDex ETF, a SPDR Dividend Aristocrats ETF, an Ossiam Minimum Variance ETF and the Lyxor SGQI ETF.