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Power of disruption: How Smart Beta is shaking up the investment universe

JOHANNESBURG — Technological developments, especially when it comes to the likes of algorithms, have opened up a whole new world for investors. The rules-based approach of ‘Smart Beta’ investing allows the advantages of an active-like approach to investing with the low costs typically associated with passive investing. And the phenomenon of Smart Beta is growing dramatically. In May this year, the Financial Times reported that Smart Beta, across the globe, drew a net $24bn in the first three months of the year, marking a 2000% rise when compared to the same period in 2016. Smart Beta Funds also account for a seventh of the $4trn invested in the global ETF market, according to the FT. Amid the interest in Smart Beta, I spoke to Chris Rule, Capital Markets Executive at CoreShares, to find out more about this type of investing. – Gareth van Zyl

This podcast is brought to you by CoreShares. I’m speaking to Chris Rule, who is the Capital Markets Executive.

Chris, what does Smart Beta Investing involve and how has this type of investing evolved over the last year, especially when it comes to dividends investing?

Thank you for taking your time to interview us. Smart Beta is really a hybrid of active and passive, and it’s a hybrid because it has similarities to passive investing insofar as it is rules based and low cost. It’s also similar to active investing because it varies from market capitalisation weighting which basically means it’s something that’s different from simply giving a share more weight in a portfolio because it’s large.

Seeing as Smart Beta is rules based and of a low cost nature, is it fair to say that it relies quite heavily on algorithms? Or is there still a big human element at play?

The human element comes in the implementation of the strategy. So, you’re quite right, the algorithm in the background is the index which we track. Effectively, what Smart Beta does is it sets out a number of rules and filters for shares which meet the criteria and that’s the algorithm side of it. Once the share has met a criteria, it will then be included in the portfolio or an index and given a weighting based on another set of criterial rules, so that’s very much algorithm based.

Chris Rule, CoreShares.

Then, what we do as CoreShares is we receive that index file and actually implement or go and buy those shares again. So, there’s much less human intervention, specifically relative to active where an active manager may take a view of one share over another for a reason that’s not purely quantitative but more qualitative. For example, he doesn’t like management or the direction the company’s moving. So, there is human interaction, but it’s limited, most specifically relative to active.

Are algorithms pushing out a lot of traders and fund managers out there?

Well, not the traders. But in terms of the fund managers – in terms of how you see the active universe – there are some active managers or fund managers who are more prone to be disrupted by Smart Beta. They are previous active managers who had a very rules based system of selecting shares, so a very quantitative based selection process. In other words, that may be what an active manager who has a dividend strategy where he looks to filter stocks that have a specific dividend yield and have a specific dividend growth metric or a track record of paying dividends.

Read also: Gareth Stobie: Disruptive Smart Beta – ‘slowly’ eating active managers lunch

A lot of those kinds of processes can be put into a very strict rules based environment and effectively packaged in a Smart Beta fund or a Smart Beta product. Not all active managers are easy to capture in a succinct set of rules, but certainly a large percentage of active management returns can be explained by their static exposure to a style or a Smart Beta. Value managers, for example, may select certain metrics to select shares, momentum managers, so on, and so forth. The active universe is more easily commoditised with the introduction of Smart Beta.

Can you tell me about your South African case study on smart beta applications and the results thereof?

Sure, we’ve been talking about Smart Beta at CoreShares for a long time and we’ve been talking about its disruptive qualities, but because, as I mentioned earlier, it is able to capture an active strategy, but implement it at a low cost and efficient way. What we’ve been talking about is a lot of theory and that we’ve recently done a case study. One of our flagship Smart Beta strategies, Dividend Aristocrats, has just reached its three-year track record. In other words, we actually have real fund data to deal with and that’s why we’ve done this.

Read also: Chris Rule: Unpacking Core/Satellite – best portfolio strategy for private investors

Effectively, what we’ve said is that Dividend Aristocrats, which is a dividend strategy, has active competitors which we believe can be commoditised in a Smart Beta strategy. We’ve compared all of the dividend active managers and both active and Smart Beta. And because it’s our competitors product, we’ve compared them to see how different their outcomes are. Subsequently, there is a significant of advantage of being in Smart Beta products like our Dividend Aristocrats relative to being in an active strategy that’s looking to buy companies with attractive dividend metrics. That’s what the research is premised on.

One of the findings is that your Aristocrats ETF platform completely outperformed some of those other funds?

Sure, so we looked at it slightly differently to the pure performance numbers. We looked at what is the objective of the fund or what is the objective of the strategy. In all of the instances of the funds we compared it to – and we compared it to the full opportunity set – we thought the primary objective of these funds was to deliver dividends to clients and to deliver sustainable and growing dividends to clients. We said that was the primary objective, so you’re quite right.

The performance of Dividend Aristocrats – in terms of the total return – was significantly better than the competitors. But what we looked at and focused more on was the ability to generate income for clients – really cash flow for clients – and there was a significant advantage of being in a Smart Beta fund. Really, it boils down to a very simple explanation and that is: dividends are paid to clients after managers have taken their fees away. If you have a high fee, naturally the dividend that will be delivered to your client will be lower and this goes for Smart Beta funds in general – passive funds are significantly cheaper than active competitors. What we’ve seen is that a lot of the active funds we compared against had higher starting yields, but, in fact, delivered a low cash flow to their clients and that was because their fees were significantly higher.

If you look at the composition of the starting yield, you can see that the percentage of that yield that is eroded by fees is much higher in active funds relative to the smart beta funds. In fact, in the smart beta funds, they’re less than 10% of the yield, whereas in active managers they range between some 30% of your income having been destroyed by high fees all the way up to close to 70%, 80% of income generated by the portfolio, which was then actually deducted in fees.

So, it’s not some black box or magical trick: it’s really simple. It’s a structural advantage that Smart Beta has over active where the fees are significantly lower. We were really trying to exhibit a very simple case study that showed, in reality, the strategy works because we can capture a lot of the same investment styles as the active managers. But then because of the lower cost, we have a structural advantage which is perpetual – in other words, which is not going to be arbitraged away unless active managers significantly reduce their fees.

Can you give us an idea of how much lower the fees are? For example how does the Aristocrats fund compare to some of the other funds out there?

On the active funds they vary because there are many classes of units and fees etc. But talking about the retail class, the active management fees range from 2.3% to around 1.3%, so that was the range. The cheapest active fund was 1.3% up to 2.3%, whereas the passive Smart Beta fund – and there were two of them within the five fund comparison – were between 0.3% and 0.45%. So, really that 1% difference in fees ends up being cash flow for the client and that’s the primary focus of the fund and it’s the objective of the client when entering into the strategy. We feel it’s a really important component of the fund structure and of the client’s experience. In fact, with regard to this dividend strategy – because we feel the primary objective is generating an income for clients – the fee differential is amplified relative to other strategies where Smart Beta may compete.

How many Smart Beta dividend strategies does CoreShares currently offer?

We have one dividend strategy in the Smart Beta space. It’s the Dividend Aristocrats, which is an S&P Dow Jones Index. The fee on that fund at the moment is 36 basis points or 0.36% and it’s a very simple strategy where we just look at companies or the S&P Dow Jones, simply select the companies which have a good track record of paying, and maintain or growing their dividend over a seven-year period, which is not dissimilar to what some of the active peers would be doing as part of their selection process.

Would you be looking to introduce more of these strategies down the line?

Well, not necessarily within the dividend space. We feel that this fund captures the equity dividend style of investing very particularly well. But certainly within other equity style strategies, we would be potentially looking at launching new Smart Beta products where we have a low volatility product for example in existence and we have equally weighted strategies which are Smart Beta to a degree. We think that this is our flagship and a good representation of a dividend equity strategy in the market.

Markets move in cycles and there are different factors that perform under different conditions. How do smart beta funds adjust themselves for this?

Smart Beta funds quite simply do not adjust themselves for this. Therefore, what you mentioned is extremely important and that’s why the focus of this research was not looking at a total return or performance level, but rather at the objective of income. Smart Beta, like any investment style, tends to be cyclical. Let’s take an active value manager, for example. He may have cyclical returns based on the economic conditions, so on and so forth. That could be captured in a Smart Beta strategy and it would be equally as cyclical as an active value manager. In terms of this case study where dividends have been popular in recent history, the returns would tend to be cyclical at a total return performance level. However, the income generated by the portfolio would be less cyclical. 

The focus really is on the income generation and the portfolio. But, absolutely, it’s something that investors have to be aware of and what we try to make them more and more aware of is the cyclicality of factors and understanding exactly why you’re buying the strategy. In terms of dividend strategies (and it’s the equivalent for the active managers as it is for Smart Beta) you would be buying an equity dividend strategy, most likely because you’re retired and you’re looking to seek income from your equity portion of your portfolio which is in excess of what you can get from the general markets. In other words, the All Share and that’s really the key objective. Therefore, if you keep your eye or your focus on what the objective of the fund is, you’re less likely to be impacted by the technicality of the return.

What kind of advice would you give to people out there looking to invest in Smart Betas and to generate more yields from dividend strategies?

Well, Smart Beta is not dissimilar to active in terms of making a decision to invest in a strategy. We always talk about there being nothing passive about making an allocation to a passive fund like smart beta. We would encourage investors to really understand the Smart Beta strategy and what the objective of that fund is. Currently, there are two Smart Beta dividend strategies (in SA), one run by us and a competitor and they’re very different strategies. Ours is more of a quality and dividend strategy, whereas theirs is more of a yield and value strategy. So, two Smart Beta and if you just read the fund name, dividend strategies are actually significantly different. So I’d really encourage investors that there is no such thing as a passive investment and any allocation is an active decision – you should do as much research on a Smart Beta fund as you would do on an active fund.

What is the demand like for Smart Beta in South Africa? Is it growing?

As I mentioned, these are all real numbers I’ve been talking and we’ve just received a three-year track record. We’ve noticed significant pick up and demand in the recent history, in the last year to six months. When I say, significant pick up and demand, it’s relative to how it was previously, but still a small percentage of money managed is sitting in Smart Beta. So, within this universe, we compared all the dividend funds.

There’s in excess of R10bn in these strategies, our smart beta strategy has over R200m, but you know, a very small percentage of the total opportunity set is sitting in Smart Beta at the moment and we think that’s a trend that will change as investors and allocators of money start realising that a lot of active management strategies can be captured succinctly in a rules based environment and then implemented at very low cost. We think it’s a perfectly good substitute product which actually benefits your clients more because you’re getting better value for money effectively out of your investments.

Chris, I think we’ve all learnt a lot about Smart Beta today and dividends and thank you very much for talking to us.

Thank you Gareth and thanks for your time.

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