Feature – Smart beta
tinued underperformance of active managers, as well as a low expected return environment. For some, smart beta works best when used for a specific rea- son, such as to deliver diversification or uncorrelated returns, rather than as a core holding in a portfolio.
Long-term benefits
And here there is a need for investors to truly understand that the outperformance of some of the factors that smart beta are based on can require prolonged periods of time to become evi- dent. A point made by Elizabeth Fernando, head of long-term investment strategy at workplace pension scheme Nest. “With smart beta investing, it’s important to commit over the long term, as risks are not rewarded consistently over time,” she adds. “At some points they can be extremely well compen- sated and others less so, and you will lag behind the market cap weighted market.” Fernando also observes: “As with all strategies, the price you buy at does matter. When many investors prioritise the same factors it can cause overcrowding and future returns can be lower.” And she warns: “There’s a need to be wary of the ‘latest hot new trend’.” An example, says Fernando, could be a green bubble in public equities as investors look to increase exposure to ‘green’ com- panies. “It’s something we are carefully monitoring and mak- ing sure we are clear on the financial case behind our level of exposure,” she adds.
Turbulent underperformance But smart beta does not always work in practice. “Smart beta funds do not offer a risk-adjusted performance superior to active and passive strategies,” noted Youssef Louraoui from École Supérieure des Sciences Economiques et Commerciales Business School, in the paper, Is smart beta smart? The failure was especially seen during the turbulent markets we saw as the Covid pandemic took hold. According to Morn- ingstar, more than half of smart-beta funds underperformed their benchmark last year. The analysis found that such funds were hurt by their propensity to be dominated by small and mid-cap stocks, which has meant they have not been as resil- ient as the overall market during the pandemic. There has also been a slowing in the number of smart beta products: 13 ETFs tagged by Morningstar as smart beta had launched in the US in the opening nine months of the year. That compares with 21 in 2020 and 65 in 2017. Although it could be a market beginning to mature because, looking at US smart beta ETFs in isolation, nearly three quarters of them were launched since 2010. Something else could be at play. Academic paper The Smart Beta Mirage found that smart beta ETFs suffered from a “sharp”
42 | portfolio institutional | November 2021 | issue 108
When many investors prioritise the same factors, it can cause overcrowding and future returns can be lower.
Elizabeth Fernando, Nest
drop in performance after they were launched. According to co-authors Yang Song at the University of Washington and Shyang Huang and Hong Xiang at the University of Hong Kong, the average return of smart beta indices drops from 2.77% per year before ETF listing to -0.44% per year after listing.
They stated in the paper: “We find evidence of data mining in constructing smart beta indexes as the post-ETF-listing perfor- mance decline is much sharper for indexes that are more sus- ceptible to data mining in back-tests. Our results caution the risk of data mining in the proliferation of ETF offerings as investors respond strongly to the stellar performance in back-tests.” None of which has stifled the popularity of smart beta. Prod- ucts classed as smart beta attracted about $44bn (£32bn) in net flows during the first nine months of 2021, according to one asset manager.
Equity-based Smart Beta ETFs and ETPs listed globally gath- ered net inflows of $27.92bn (£20.31bn) in the first quarter of 2021, bringing year-to-date net inflows to a record $57.4bn (£41.76bn), which is higher than the $8.97bn (£6.53bn) gath- ered at the same point last year. Year-on-year through the end of the first quarter of 2021, Smart Beta Equity ETF/ETP assets increased by 12.5% from $1trn (£728.6bn) to $1.12trn (£816bn), with a five-year compound
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