Smart-beta funds are somewhere between active and passive investment products. Most of them are exchange-traded funds (ETFs) that replicate a non-market-cap-weighted index. These alternative indices are designed to target factors such as value, growth, low volatility, high yield or quality.
Coverdale finds smart-beta strategies interesting in principle because they could offer investors more sophisticated exposure while providing portfolio diversification. However, he has concerns about how the products are built.
If smart beta focuses on a particular factor, some of the assets in the portfolio may have characteristics that are driving returns that the manager is not looking at.
“You might choose the top 20 low volatility stocks [and the majority of them] might be banks, because banks may happen to be low volatility at the moment. Am I taking on a bank risk or a low volatility risk, and if they are Chinese banks, am I taking a country risk?”
He added that there is also no consistent way of constructing a smart-beta product and that managers do not necessarily hedge out other risks.
He suggests that investors try to understand the true return drivers of a portfolio by looking at scenario tests and risk exposures to make sure that the returns are completely driven by a factor and not by something else.
In addition, investors should also be aware of the metrics being used in a smart-beta strategy.
“What is the measure of volatility that is being used and is it the right measure? Because there are lots of ways I can measure volatility. There is no right answer, and therefore it really comes down to the investor to say ‘I am happy with that definition of low volatility’.”
Another challenge for smart-beta products is determining whether they have performed well. He said there is no relative measure in the smart-beta space.
“If it goes up 10% in a year, how do I know if the 10% is a good result or not? At least in the traditional space, I have my traditional index like the S&P 500.
“It is kind of a marketing dream.”
Smart-beta managers are advised to be more transparent in their investment processes, especially for retail investors. Institutional investors are more aware of the issues of smart-beta strategies, especially since a number of them have been doing it in-house, Coverdale noted.
“Whilst things are going well, it doesn’t matter because people don’t notice. But as soon as things are not going well, people are going to start asking a lot of questions about how these things are constructed.”
In an analysis made by Morningstar, only 24% of US smart-beta funds did better than replicate portfolios of Morningstar market-cap-weighted indices.
Nonetheless, smart beta is gathering assets. In Asia-Pacific including Japan, assets under management in smart-beta ETFs grew 57.1% between June 2016 and June 2017 to reach $16.9bn, according to Morningstar. Despite the growth, market share remains small, accounting for only 4.3% of total ETF assets in the region.