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Wondering what smart beta funds are and whether to invest in them? Helena Conradie, CEO of Satrix, provides an excellent, easy-to-understand overview of alpha and beta and how index funds, like ETFs (Exchange Traded Funds) try to capture alpha. In a nutshell: smart beta funds are index-trackers on steroids. They aim to deliver above-average market returns like a fund manager does – in a more cost-effective way. – JC
By Helena Conradie*
Over the past few years, passive investment funds have burgeoned into a range of styles and types, many of which were not around 20 years ago. The real interest today is in the more sophisticated, but largely misunderstood smart beta funds. What exactly is smart beta?
Alpha and beta
Most investors will be familiar with the investment terms ‘alpha’ and ‘beta’. Beta is the volatility of a portfolio relative to that of the market as a whole. The market has a beta of 1. If your portfolio has a higher or lower beta, it is more or less volatile than the market. If you employ an active fund manager (one who studies companies and chooses a basket of shares for you) who gives you a return (and probably risk) which is different to that of the market (either positive or negative), this under- or outperformance of the market is called alpha.
Both measures are compared to a benchmark, which in this case is the market. A fund which has a beta of 1 is synonymous with the market and will often be called a tracker, even if the underlying components don’t look exactly like the market index (i.e. it behaves just like the market).
The punches are in the weight. Ultimately, alpha is the result of the manager weighting stocks differently to the index. For example, if Naspers makes up 10% of the JSE All Share Index, but the manager allocated only a 5% weight to it, and Naspers underperforms the index, this underweight creates positive alpha. Likewise, if the manager allocated 20% to Naspers and it underperforms, the overweight results in negative alpha. Basically, to create positive alpha, you need to be underweight in underperforming stocks and overweight in outperforming stocks.
Smart beta funds attempt to capture excess return (or alpha) in a systematic – or rules based – way. The simplest example is the Satrix Equally Weighted Top 40 Index Fund. The rules dictate that the top 40 stocks are equally weighted in the portfolio as opposed to market cap weighted. This will result in a different beta to the FTSE/JSE Top 40 index – hence smart beta. The idea is to deliver a better return while taking on different risk than the JSE Top 40 index – at a lower price.
The drawing below shows the different ways in which passive funds can weight their stocks.
1. Market cap weighted
Market cap weighted indices are built using the top 15, 25, 40 or even 500 shares listed on a specific stock exchange. The companies are ranked and weighted in the same order as their market capitalisation (number of shares in issue for the company x share price) on the relevant exchange. It is important to note that a market cap weighted index is not considered a smart beta fund, as it is simply tracking the market.
2. Equally weighted
As an example, the Satrix Equally Weighted Top 40 Index Fund invests in the top 40 stocks on the JSE in equal weights as opposed to ranking them by market cap. Each of the 40 stocks receives a 2.5% weight in the equally weighted index.
3. Fundamentally weighted
An example of a fundamentally weighted fund is the Satrix Rafi 40 Index Fund. All the shares on the JSE are screened in terms of the so-called fundamentals (sales, cash flow, book value and dividend) of the last five years’ audited values. The 40 top-ranking companies with respect to these criteria are included in the fund.
Smart beta: you can choose what to capture
The result of weighting stocks differently to the JSE is that you have a fund which differs from the JSE in terms of:
* Individual stock exposure
* Sector exposure (for example resources, financials and industrials)
* Factor exposure (for example foreign, size, yield and market sensitivity).
The sector and dramatically different factor exposures of the Satrix Top 40, the Satrix Equally Weighted Top 40, the Satrix Rafi 40 and the Satrix Dividend Plus Index funds are shown below.
Most of the criticism levelled at passive investments focuses on market cap weighted indices, which simply mimic some of the larger indices such as the JSE All Share Index or the JSE Top 40 Index. These index funds have been accused of being heavily exposed to overvalued stocks and less so to undervalued stocks. Smart beta offers the more sophisticated investor the opportunity to invest in a different sector or factor exposure than is characteristic of the broader market cap indices.
For example, if you felt that the market was better suited to value investing, you would consider the Satrix Rafi 40 Index Fund. Alternately, if you felt that it was a growth market, you may consider the Satrix Momentum Index Fund. Your passive fund now becomes an active choice in your portfolio as you make a selection which will give you a different performance profile than that of the market.
* Helena Conradie is CEO of Satrix.
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