Infocus Report: Smart beta is here to stay

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17/07/2017

SPONSORED CONTENT | Global asset owners hungry for risk-adjusted returns and searching for ways to improve the diversification of their portfolios are pouring into smart beta strategies. Increasingly, they favour a multi-factor approach, and ESG factors are tipped to be the next big thing.

Nearly half of all institutional investors globally are already using smart beta strategies, and the rate of adoption is tipped to skyrocket in the coming years. Traditional smart beta strategies, such as those based on fundamental valuations, remain popular. However, there is also booming demand from institutional asset owners for smart beta products that will be used for multi-factor and sustainable investment strategies. This is tipped to turbo-charge inflows.

FTSE Russell recently surveyed 194 global institutional asset owners with total assets under management (AUM) estimated at more than US$2 trillion ($2.7 trillion) about their approach to smart beta.

A record 46 per cent of the investors surveyed are already incorporating smart beta strategies in their portfolios. While Australia was not singled out in the survey, the rate of smart beta adoption across the Asia-Pacific region was 48 per cent, well behind Europe, at 60 per cent.

FTSE Russell managing director of North America research, Rolf Agather, predicts that based on FTSE Russell’s survey, the uptake of smart beta among institutional investors will continue to rise in the coming years.

He says asset owners are embracing smart beta as more data and investor education become available and new products – such as multi-factor and environmental, social and governance (ESG) indices – hit the market.

“Smart beta is more than just a fad,” Agather says. “We expect growth in smart beta to continue at a robust pace, as, according to our survey results, the adoption expectations of asset owners currently evaluating initial or additional smart beta allocations remains strong and satisfaction with smart beta among current users remains high.”

He believes smart beta’s appeal is that it offers investors additional choices beyond traditional active and passive approaches.

“For investors who like the transparency, low cost and discipline of an index-based approach but want to overcome some of the limitations of market cap-weighted indices, smart beta can provide a variety of options that are distinct from traditional indexes,” Agather says.

Smart beta is a catch-all term that covers a wide range of systematic, index-based investment strategies. Smart beta indices select and weight their constituents differently from the standard methodology of weighting based on market capitalisation.

The FTSE Russell survey shows the majority of asset owners that are using smart beta are typically using more than one strategy. Two-thirds of those who have allocated to smart beta are using two or more smart beta strategies and 26 per cent are using four or more.

Multi-factor in vogue

Nearly two-thirds of the smart beta adopters in the FTSE Russell survey were using multi-factor strategies, more than triple the 20 per cent using multi-factor in 2015. Among the new adopters (those who have had a smart beta allocation for less than two years), 71 per cent were using multi-factor strategies.

“Asset owners and consultants are harnessing the full spectrum of smart beta tools available,” Agather says. “If the trend revealed in our survey continues over the next five years, a substantial majority of institutional asset owners will have some amount of smart beta allocation.”

Many of the newly launched smart beta ETFs have been underpinned by multi-factor indices.

“The appeal of multi-factor is not surprising because it provides investors with a product that can be tailored to their requirements. They can choose their factors – typically three to five – and have the option of applying different tilts to each,” Agather says.

He predicts that, based on the FTSE Russell surveys and research, growing demand for ESG strategies is likely to be among the next big drivers of smart beta adoption.

More than 40 per cent of asset owners in the FTSE Russell survey that have, or are planning to evaluate, a smart beta allocation, indicated they anticipate applying ESG screens or factors to a smart beta strategy. In Europe, the proportion is 60 per cent, increasing to nearly 80 per cent among asset owners with AUM greater than US$10 billion ($13.5 billion).

Considerations related to expected financial performance were the main reason given for adoption of smart beta strategies, and were also the primary motivations for selecting ESG factors. A desire to avoid long-term risks, such as climate change, was the most commonly cited reason. Regulatory requirements figured less prominently.

ESG factors on the rise

Around the world, a growing number of major institutions are acknowledging their exposures to climate-related risks. They want to ensure their portfolios build in some protection and secure some potential up-side opportunities associated with climate change, such as growth of green industries. Smart beta strategies incorporating relevant climate change parameters can be a useful tool to achieve this.

The trustees of HSBC Bank UK Pension Scheme adopted a climate change policy in 2015 and more recently implemented a climate aware fund for its defined contribution scheme equity default option, worth £1.85 billion ($3.2 billion). Legal & General Investment Management (which managed the previous passive default option) collaborated with HSBC, its asset consultants and FTSE Russell to create a new smart beta-based fund with a focus on providing better risk-adjusted returns to members.

LGIM created its Future World Fund in consultation with HSBC, FTSE Russell and asset consultants. The fund uses the FTSE All-World ex CW Climate Balanced Factor Index, which combines a climate change tilt with a smart beta multi-factor approach.

The index applies tilts towards four factors that have outperformed against a market cap weighted index since 2000 – value, low volatility, quality and small size. The three climate change parameters tilt exposure away from carbon emissions and carbon reserves and towards companies with revenues from green industries. Both the traditional risk-premia factors, as well as climate parameters in the historical analysis, deliver out-performance above the market cap-weighted benchmark.

“We believe this fund will offer our members a better risk-adjusted return, incorporate some climate change protection and deliver improved company engagement,” HSBC Bank UK Pension Scheme chief investment officer Mark Thompson says.

Fundamentals endure

LGIM’s Future World Fund used by HSBC is just one example of how major investors are discovering more possibilities for employing smart beta.

While multi-factor and ESG strategies are driving increased adoption of smart beta, more mature styles – such as  fundamentally weighted strategies – remain significant in absolute terms, particularly with investors who were earlier adopters of the investment style.

Among institutions that have had smart beta allocations for more than two years, 34 per cent have an allocation to a fundamental strategy, compared with 13 per cent of those who have had smart beta allocations for less than two years. Among those considering making their first smart beta allocation, one-quarter are still considering a fundamentally weighted strategy.

Success story

BetaShares FTSE RAFI Australia 200 ETF (ASX code QOZ), a fundamentally weighted smart beta exchange traded
fund, was one of the first smart beta ETFs launched in Australia.

It provides exposure to a diversified portfolio of Australian equities that are fundamentally weighted in a way that is reflective of the economic footprint – sales, cash flow, book value and dividends – of its constituent companies.

“We listed the fund on the Australian Securities Exchange four years ago as a better way to track an index without the shortfalls of a cap-weighted index,” BetaShares director institutional business and national accounts Vinnie Wadhera says.

The product was launched with all market segments in mind – institutions, advisers and retail investors – but the strongest support has come from institutional investors.

”We have seen continuing strong growth in AUM since its launch. It’s not surprising when you look at the performance of the ETF and the underlying index,” Wadhera says.

Today’s AUM of $210 million compares with $60 million two years ago and $88 million one year ago. QOZ’s  performance after fees compared with Australian active managers (using the Morningstar Australian Equity Large Growth and Australian Equity Large Blend categories), places it in the top quartile of all active managers. Over three years to March 31, 2017, it would have ranked 23rd out of 195 and, over one year, second out of 211 managers.

“Longer term, the FTSE RAFI Australia 200 index has outperformed the S&P ASX 200 index by an average 2.2 per cent per annum since its inception in August 2009. It all comes back to the index and its methodology, including annual rebalancing on fundamental weights,” Wadhera says.

Boom to continue

The global market for smart beta ETFs is booming and double-digit growth is forecast to continue. In Australia and overseas there has been a proliferation of smart beta ETFs with assets predicted to reach US$1 trillion ($1.35 trillion) by 2020, representing 19 per cent per annum growth from 2016, according to BlackRock.

Agather expects there to be continued evolution in multi-factor combinations, including increasing incorporation of
ESG – particularly in Europe and other ESG-sensitive markets.

“There is also increasing talk and debate about the potential to time factors, so it is reasonable to expect an increasing number of dynamic factor strategies coming to market in the next few years,” he says. “We are also beginning to see interest in smart beta in other asset classes, such as fixed income.”

This Investment Magazine Infocus report, sponsored by FTSE Russell first appeared in the July 2017 print edition of Investment Magazine. To subscribe and have the magazine delivered CLICK HERE. To sign-up for our free regular email newsletters CLICK HERE.