By Konrad Sippel
Smart beta has become a buzzword within the industry. Index concepts relying on methodologies alternative to the traditional market cap weighted benchmarks are mushrooming and investors increasingly consider these.
For example, smart beta exchange traded products (ETPs) saw 2013 inflows of $65.1bn or nearly one third of overall ETP inflows, according to BlackRock. However, there is some confusion around the term “smart beta”. BlackRock, as well as many others, considers all non-market cap-weighted equity indices as smart beta including, for example, strategies such as an equal weighting, a fundamental index selection, dividend strategies and many more. Smart beta in its literal sense and a narrower definition describes index concepts optimising the market risk or the risk-return-profile based on portfolio theory, such as the Minimum Variance indices.
Why have strategy and smart beta indices become so popular? Most importantly, they seem to offer what many investors are looking for: an easy and cost-efficient way to better than market risks or returns, and that via index products. Secondly, we, as an industry, are now able to provide investors with a wide range of different approaches and investment strategies via indices, as the methodologies in indexing are continuously improving. Investors benefit from this broad offering as it allows them to find index based solutions for very specific investment objectives. These comprise income solutions, risk optimised portfolios or strategies that were once the sole playing field of active managers, such as stock picking based on fundamental key figures.
While all these concepts have their benefits, it is, of course, not quite that easy to improve beta. There is a trade-off between the benefits of each strategy and optimisation, on the one hand, and factors worth considering for an investment, on the other. For example, some strategies improve the risk or return of the respective portfolio based on regular changes in its composition, thus leading to higher transaction costs in the actual, replicated portfolio. In addition, investors need to fully understand the characteristics of the respective strategy or smart beta index to choose the one appropriate for their specific investment need and to be aware of associated risks or costs. Of course, this becomes more difficult with the more complex strategies and index structures, while – on the other hand – benefits and risks of the traditional market cap-weighted indices are more commonly known and understood.
So where are we headed? We are just at the beginning of the development of strategy and smart beta indices and their growing usage by investors. However, the challenges mentioned above need to be addressed so that investors can fully leverage the promising tool kit of innovative index concepts: First of all, lasting success of the concepts is based on transparency. It needs to be clarified what investment function is intended with the respective concept. And: all data necessary for a sound investment evaluation needs to be provided. For example, the respective portfolio turnover should be disclosed, allowing investors to assess their transaction costs. In addition, the indices need to be calculated independently and in a strictly rules-based way to exclude any conflicts of interest, and to ensure that the calculation is in the best interest of investors.
Konrad Sippel is global head of business development at STOXX
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