Even investment’s ‘silver bullet’ is not bulletproof

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INVESTMENT ANALYSIS

Even investment’s ‘silver bullet’ is not bulletproof

‘Smart beta’ ETFs punted as low-cost answer to actively managed products, but even they don't look very clever at times

Chris Gilmour

ETFs (exchange traded funds) now account for almost 25% of total net assets of globally-regulated open-end funds, which is not bad for an asset class that only came into existence 25 years ago. Now they’re all the rage, both in the US and in most of the world, mainly due to their low cost and the fact that, perhaps counter-intuitively, they tend to frequently beat their actively managed counterparts.
The global ETF industry continues to innovate and one of its current offerings is the so-called “smart beta” ETF which contains an element of active management while still conforming to the basic tenets of passive asset management.
Smart beta defines a set of investment strategies that emphasise the use of alternative index construction rules to the traditional market capitalisation-based indices. So, for example, an index could be constructed that contains only small cap stocks and the ETF would track that index. This is a very simple example of how smart beta works.Regarding the traditional ETFs, a major advantage of a cap-weighted (or vanilla) index is low turnover (the weights of the stocks in the index change as the market value of the stocks change), and hence tracking is easy and expenses will be low.
However, vanilla ETFs also have their detractions. Firstly, a market-cap weighting can put more emphasis on companies that might be most overvalued by the stock market and less concentration on stocks that are possibly undervalued. This is certainly the case in SA, with a huge overweight position in the extremely expensive Naspers. 
And secondly, the cap-weighted indices can also be quite concentrated with a small proportion of stocks making up the bulk of the index weights. Once again, this is true for SA, where roughly 70% of the JSE market capitalisation is accounted for by the top 10 stocks.
In the case of the S&P 500 index, the largest 50 stocks make up almost half the index and the largest 100 make up almost two-thirds.In a highly concentrated market, a vanilla index becomes badly distorted to the extent that if anything untoward happens to a large component of that index (such as Naspers for example) it will have a disproportionately large effect on the index.
In South Africa, passive investment management group Coreshares has moved to the forefront of the ETF movement. Its recent conference was dedicated to all things ETF-related, with a focus on smart beta. Speaking at this event, Nick Motson of the Cass Business School in London demonstrated that cleverly-designed smart beta products out-perform their standard market cap-weighted ETF peers.
In 2014 he and his colleagues indulged in a gargantuan number-crunching exercise to prove the validity of smart beta. They examined eight alternative index methodologies which are all available as commercial products and have become collectively known as smart beta. These methodologies were Equally Weighted, Diversity Weighted, Inverse Volatility, Equal Risk Contribution, Minimum Variance, Maximum Diversification, Risk Efficient and Fundamentally Weighted. They were applied to a common set of stocks over a 45-year period.All eight of the alternative indices delivered higher returns than the market cap-weighted index. Over a 45-year period, the mean return from a market cap-weighted index was 10.62%; the others varied from 10.83% to 12.03%. Five out of eight had lower volatility – and all eight had a higher Sharpe ratio, which is the measure of risk-adjusted returns of a financial portfolio. A portfolio with a higher Sharpe ratio is considered superior relative to its peers.
The back-tested historical risk-adjusted returns of smart beta indices look good when compared to a market cap-weighted index. The outperformance can be explained by exposure to value and size factors. Generally, small caps and low PE/value stocks (which by definition are not in the traditional ETFs) generate higher returns relative to the large cap and high PE stocks.
But results also showed some periods of severe underperformance for all the smart beta approaches. So as “smart” as it undoubtedly is, smart beta is not bulletproof.
Chris Gilmour is an investment analyst.

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