As more and more investors lose faith in active managers, they are increasingly turning to a compelling alternative – smart beta. Combining elements of both active and passive management, smart beta strategies have enjoyed significant inflows in the past few years and continue to see growing interest from investors.

Michael Larsen, Global Head of Affiliate Relations at Research Affiliates.

The latest evidence for this comes from FTSE, a global index provider, which has announced that assets under management (AUM) in exchange-traded funds (ETFs) linked to the FTSE RAFI index series, a popular range of smart beta indices, have topped $5 billion.

Launched in 2005 in partnership with smart beta specialist Research Affiliates, the FTSE RAFI index series was among the first to drop the market capitalisation-weighted approach where the largest stock receives the largest weight and the smallest stock receives the smallest weight.

This approach, still practised by the majority of indices, has a number of significant drawbacks, most notably that portfolios can become concentrated in a few large positions and that overvalued stocks are overweighted.

By breaking the relationship between market capitalisation and index weight, the FTSE RAFI Index Series epitomises the smart beta alternative. Rather than using market capitalisation, index constituents are weighted in proportion to their fundamental strength – a function of total cash, dividends, free cash flow, total sales and book equity value. The stock with the highest fundamental value receives the largest weight while the stock with the weakest fundamental value receives the smallest weight. In real terms, this translates into a portfolio which, when compared to a market cap-weighted equivalent, underweights overpriced stocks and overweights undervalued stocks.

Since launch, the series has expanded to include an array of global, regional and single country indices, which, in turn, have been adopted as underlying benchmarks for a range of ETFs, mutual funds and institutional mandates holding in aggregate some $30 billion in assets. In terms of ETFs, FTSE RAFI-based products are available on nine exchanges across North America, Europe and Asia from providers including iShares, PowerShares, Lyxor and Satrix.

Commenting on the milestone, Jonathan Horton, President of FTSE Americas and Head of FTSE’s ETP Service Unit, said “FTSE was an early pioneer of alternative weighted indices” and that the milestone “highlight[ed] increasing investor interest in accessing new forms of passive exposure.”

Michael Larsen, Director, Global Head of Affiliate Relations for Research Affiliates, expressed a similar sentiment. He said: “Investors around the world are increasingly turning to smart beta solutions, such as the FTSE RAFI Index Series, as a way to capture potential outperformance while retaining the benefits of traditional market cap-weighted indices – transparency, broad economic representation, and liquidity at a relatively low cost.”

Rival indices include the Russell Fundamental Index Series, which weights constituents according to a fundamental measure of company size incorporating adjusted sales, operating cash flow, and dividends plus buybacks; the MSCI Value Weighted Indices, which, similarly, weight constituents according to sales, earnings, cash earnings and book value; and the S&P GIVI (Global Intrinsic Value Index) indices, which weight stocks based on book value and discounted projected earnings.

When it comes to ETFs, the strongest challenge to those linked to the FTSE RAFI series probably comes from First Trust‘s AlphaDEX range and WisdomTree‘s in-house earnings, dividend, growth and value products. The new Barron’s 400 ETF (BFOR), which debuted last week, is also likely to provide competition.