Smart beta without the marketing spin

If you’ve heard the phrases ‘best of both worlds’, ‘smart indexing’ or ‘intelligent exposure’ in relation to an ETF, it’s highly likely that the ETF uses a smart beta approach to investing. 

It all sounds catchy and appealing, but highly confusing. After all, what are you actually trying to achieve when it comes to smart beta, and what does it do? 

Smart beta is not just one strategy, and you won’t know which until you take a deeper dive into your ETF. You could say that smart beta is still passive – with a twist. 

Key takeaways 

• Smart beta aims to enhance market returns by tracking a tailored index.  
  
  
• Tailored indices in smart-beta investments are constructed differently to broad-based market indices, which are built using market capitalisation (largest allocations to largest companies, smallest allocations to smallest companies). 
  
  
• The three main types of smart-beta index constructions include factor/multi-factor investing, capping and alternative weighting. 
  
  
• Some positives of using smart beta include targeted investing, lower costs compared to active strategies, transparency and the potential for higher returns, while some negatives include higher costs than passive strategies, concentration risk, the potential for underperformance and the possibility of higher portfolio turnover. 

Passive, active and finding a middle ground 

The traditional form of an ETF is passive, and what this looks like is seeking to follow the market performance via a broad-based index, such as the S&P/ASX 200 or the S&P 500. 

The key goal is to match the market. The key approach is track the index. 

Some examples of passive ETFs include Betashares Nasdaq 100 ETF (ASX: NDQ), which tracks the Nasdaq 100 Index, or the Vanguard Australian Shares ETF (ASX: VAS), which tracks the S&P/ASX 300 Index. 

Active ETFs seek to outperform the market (as based on a broad-based index like the S&P 500) by a targeted amount using strategies like fundamental and quantitative analysis to select investments. 

The key goal is to outperform the market. The key approach is active investment selection. 

Some examples of active ETFs include the Airlie Australian Share Fund – Active ETF (ASX: AASF), which aims to offer long-term capital growth above the S&P/ASX 200 Accumulation Index through a concentrated portfolio of Australian equities, or the JP Morgan 100Q Equity Premium Income Active ETF (Managed Fund) (ASX: JPEQ), which aims to offer income and capital appreciation associated with the Nasdaq 100 Index with less volatility by investing in option premiums and stock dividends. 

Smart beta is designed to offer a middle ground between the two by tracking an index that looks different to the traditional broad-based index in the hope of offering better investment returns. This could look like less volatility, or higher yield, or a range of other desired characteristics. There is a level of aiming to outperform the general market, but while active managers might be aiming to shoot the lights out, this is more about enhancing certain aspects of returns. Think the broad-based market index with a particular extra rules filter on it. 

The key goal is ENHANCED MARKET RETURNS. The key approach is RULES-BASED INDEX INVESTING. 

Some examples of smart-beta ETFs include Global X S&P/ASX 200 High Dividend ETF (ASX: ZYAU), which tracks the S&P/ASX 200 High Dividend Index. This index filters the S&P/ASX 200 Index by the 50 highest 12-month forecast dividend-yielding companies to offer higher dividend yield compared to the broader market. Another example is the VanEck MSCI International Quality ETF (ASX: QUAL), which tracks the MSCI World ex Australia Quality Index. The MSCI World ex Australia Quality Index filters the MSCI World ex Australia Index by quality as categorised by high return on equity, earnings stability and low financial leverage with the view that focusing on quality businesses only will outperform the broader market index. 

Types of smart beta strategies 

Smart beta still relies on an index, but the index is constructed differently.  

Broad-based indices are typically constructed based on market capitalisation, meaning the biggest companies have the biggest allocations in the index, and the smallest companies have the least money allocated to them.  

Smart beta indices might still use market capitalisation as part of the construction – but they also might not.  

There are generally three types of construction for smart beta. 

1. Factor/multi-factor 

In this form, one or more additional filters are applied to the broad-based index. These could be factors like Quality, Value and Momentum, or desired characteristics like dividend yield or low volatility. 

2. Capping 

A ‘cap’ or maximum is set on how large an allocation can be in the index to avoid small companies dominating the fund. 

3. Alternative weighting 

Rather than use market capitalisation to set the company weights in an index, an alternative method is used. Equal weighting is one common option where all companies have the same size of allocation regardless of how big the company is. Price weighting is another option where the allocation size in the index is based on the price per share. Fundamental weighting is where each company is weighted based on underlying metrics, such as sales, book value, cash flow, or dividends (or a weighted combination of these). Diversity weighting blends market size with equal weighting to offer diversification with smaller companies. 

Pros and cons of smart beta investing 

Just because smart beta investing has a goal to enhance returns doesn’t always make it the better option for investors. You need to weigh up the individual strategy and what it offers your portfolio. 

Some pros for smart beta include: 

• The ability to focus on desired characteristics for your portfolio, such as quality or income. 
• The potential for higher returns compared to the broader market. 
• Typically lower cost compared to actively managed strategies. 
• Transparent and typically easy to understand the strategy. 

Some cons for smart beta include: 

• May be more expensive compared to standard broad-based passive strategies. 
• May underperform compared to the broader market depending on the filters used. 
• May have concentration risk if it tilts more towards certain sectors or company sizes. 
• Depending on the strategy or weighting, may have higher levels of stock turnover to continue to meet rules, which can translate to capital gains or losses with accompanying tax implications. 

How to decide on smart beta 

For many investors, using broad-based passive strategies may best suit their overall portfolios. For others, some reasons to consider smart beta strategies may be to incorporate a specific target or tilt in their portfolio, or to offset concerns about market concentration.  

Depending on the strategy, smart beta ETFs are often considered complementary to existing passive strategies rather than a replacement for them. For those using a core-satellite approach to investing, smart beta often sits more in the satellite portion. 

Smart beta strategies are still largely passive – they track an index that looks different to the broad-based market, so it’s worth remembering that it’s not about analysts individually measuring stocks but rather a system of rules that the strategy follows. If you want a more individualised approach to investment selection, that may be the trigger to consider more active strategies. 

Smart beta can be a valuable tool in a portfolio, but it’s important to take the time to understand the strategy in full and what it means to your broader portfolio to decide whether or not it is the right approach for you. 

Frequently asked questions about smart beta investing 

What is smart beta? 

Smart beta tracks an index constructed differently to broad-based indices with the aim of outperforming the broader market. 

How is smart beta different from passive and active investing? 

Passive investing tracks a broad-based index with the aim of matching broad market returns. Smart beta still tracks an index, but the index is constructed differently to a broad-based index with the aim of outperforming broad market returns. Active management doesn’t track an index and involves analyst selection of stocks with the aim of outperforming the broader market.  

There are typically higher costs involved in active compared to smart beta and passive strategies. As smart beta requires a different index, it may have higher costs compared to passive strategies. 

What are the common types of smart beta strategies? 

There are broadly three types of smart beta strategies, including factor/multi-factor investing, which targets specific characteristics like quality or value; alternative weighting, where the index doesn’t follow the standard market capitalisation weighting and may use equal weighting, price weighting, fundamental weighting and diversity weighting; and capping, which sets a maximum investment allocation per asset. 

What are the key risks of using smart beta? 

The key risks involved in smart beta investments include the potential for underperformance compared to the broader market, concentration risk, the risk of higher turnover and the potential to be more expensive compared to passive strategies. 

Funds mentioned: 

Betashares Nasdaq 100 ETF (ASX: NDQ)

Invest in the Nasdaq 100 in a single trade

Retail Investor

Objective

Growth

Category

ETFs

Min. Investment

$1

Liquidity

Listed

Availability

Open for investment

Funding Stage

Listed

Structure

ETF

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ASX: VAS

Vanguard Australian Shares ETF

Vanguard Australian Shares Index ETF seeks to track the return of the S&P/ASX 300 Index before taking into account fees, expenses and tax.

Retail Investor

Objective

Growth and Income

Category

ETFs

Min. Investment

$1

Liquidity

Listed

Availability

N/A

Funding Stage

Listed

Structure

ETF

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Airlie Australian Share Fund - Active ETF (ASX: AASF)

The Fund’s primary investment objective is to provide long-term capital growth and regular income through investment in Australian equities.

Retail Investor

Objective

Growth and Income

Category

ETFs

Min. Investment

$1

Liquidity

Unlisted liquid

Availability

Open for investment

Funding Stage

Unlisted Mature Fund

Structure

Managed Fund

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JPMorgan US 100Q Equity Premium Income Active ETF (Managed Fund) (ASX: JPEQ)

Designed to provide current income while maintaining prospects for capital appreciation.

Retail Investor

Objective

Growth and Income

Category

ETFs

Min. Investment

$500

Liquidity

Listed

Availability

Open for investment

Funding Stage

Listed

Structure

ETF

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Global X S&P/ASX 200 High Dividend ETF (ASX: ZYAU)

Invest in a selection of quality dividend-paying companies.

Retail Investor

Objective

Growth and Income

Category

ETFs

Min. Investment

$500

Liquidity

Listed

Availability

Open for investment

Funding Stage

Listed

Structure

ETF

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ASX: QUAL

VanEck Msci International Quality Etf

QUAL gives investors exposure to a diversified portfolio of quality international companies listed on exchanges in developed markets around the world (ex Australia). This fund aims to provide investment returns, before fees and other costs, which track the performance of the Index.

Retail Investor

Objective

Growth

Category

ETFs

Min. Investment

$1

Liquidity

Listed

Availability

N/A

Funding Stage

Listed

Structure

ETF

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Disclaimer: This article is prepared by Sara Allen. It is for educational purposes only. While all reasonable care has been taken by the author in the preparation of this information, the author and InvestmentMarkets (Aust) Pty. Ltd. as publisher take no responsibility for any actions taken based on information contained herein or for any errors or omissions within it. Interested parties should seek independent professional advice prior to acting on any information presented. Please note past performance is not a reliable indicator of future performance.