Stockmarket indices – once a useful but dull corner of the investment world – are big business these days. Major index providers, such as MSCI or S&P Dow Jones, are worth billions of pounds. This is largely down to the rise of passive investing and exchange-traded funds (ETFs), which track various indices on a daily basis. Investors are also demanding ever-more sophisticated indices that can replicate key investment strategies, leading to the next great fund management gold rush – smart beta.
A smart beta index makes use of ‘factors’ that have been found to boost returns over time – they screen for stocks that are cheap (in relative share-price terms) or boring (in terms of volatility), for example. They promise the benefits of passive investing – low cost, simple to understand and less volatile – but also the better returns you might hope for from good active management.
More active than you think
So do they work? Before we answer that, it’s worth understanding that even mainstream passive indices – the FTSE 100, S&P 500 or MSCI World index, say – are more “active” than you might think. Andrew Lapthorne and index specialist John Carson at Société Générale found that the MSCI World index (around 1,600 stocks) “saw over 4,000 weighting changes last year”. Of those, around 1,100 were “significant”. That’s a lot of activity for a “passive” index. Those transactions raise trading costs, and so hit returns. Given that the main point of passive investing is to keep costs down, this is worth remembering when considering smart beta options.
Most smart beta indices fall into four categories. Value indices focus on how cheap a stock is, using ratios such as the price/earnings ratio. Momentum-based strategies track a share’s strength against the wider index. Quality strategies might look for shares with low volatility.
And dividend-based ideas focus on yield. A quarter of big institutions (those with more than £1bn under management) already use smart beta, and another 40% are considering it, notes French business school EDHEC. Mostfavour either low volatility or value investing, and they aren’t looking to replace traditional active managers. Instead, smart beta helps to prevent overexposure to just a few vast businesses within a given index. The indices also allow managers to combine different factors to help improve returns over the stockmarket cycle.
No fund for all seasons
But how well do they work? Marie Brière of Paris Dauphine University and Université Libre de Bruxelles (ULB), and Ariane Szafarz of ULB last month put out a study: Factor-Based v. Industry-Based Asset Allocation: The Contest.
The study compared smart beta indices with traditional sector indices (those that track just banks or miners, for example) in varying economic and market backdrops. Smart beta was more profitable during “expansion times and bull periods… however, sector investing delivers better – or less bad – performances for long-only portfolios during recessions and bear periods”. Other evidence echoes this research – that different factors and indices work better under different market conditions.
Lyxor index experts Thierry Roncalli and Jean-Charles Richard examined which smart beta factors worked best in each of the last seven years. To cut a long story short, they found that it varies dramatically. For example, indices that favour small caps beat the market in 2014, but massively underperformed in 2012; low beta indices were stars in 2008, but has-beens in 2013. So investors need either to diversify across smart beta strategies, or carefully time their switching between them.
The cost of ‘smart’ indexing
It’s no surprise that you can’t just “buy and hold” and expect smart beta always to beat the market. But there’s a hidden risk here that brings us back to our first point – that despite the name, these indices are far from passive, which drives up costs. The Société Générale researchers also looked at a group of smart beta indices and found that their underlying composition changed greatly over time. Quality or value-based indices can boast a turnover that is more than ten times that of traditional indices.
From 1995 to 2015, a value version of the MSCI World index had 30 times more changes than the standard index. The resulting trading costs inevitably hit returns: the analysts estimated that, over the same period, the total cost of a value-based version of a world stocks index was 99 basis points (0.99%), versus less than one basis point (0.01%) for the traditional index.
Their advice? It makes sense to use the concepts behind smart beta, such as value or momentum investing – but the indices themselves aren’t necessarily the best way to do it. For example, it’s not sensible to rebalance your holdings on the same day as everyone else, which is effectively what these indices do – if everyone is selling a share that’s been ejected from the index to buy one that’s been promoted, the price of the former will be artificially depressed while you’ll pay over the odds for the latter. In short, don’t be swept away by the hype – before you invest, make sure you understand the index, and realise that smart indexing nearly always comes with a cost.