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By Helena Conradie*
This is the fourth in our series of “Satrix shares…” articles and we’re about to dial it up. So far, we’ve explained where index tracking originated and how you use it. At Satrix we’ve always said index tracking is “anything but passive”, and smart beta is largely the reason why.
Index tracking has been around for more than 20 years, but the real interest today is in the more sophisticated, but largely misunderstood smart beta index tracking funds.
So, what exactly is smart beta?
Let’s start with alpha and beta
Before I can explain smart beta, I need to define the investment terms beta and alpha. Simply put, beta is the volatility of a portfolio relative to the market as a whole. The market’s beta is equal to one. If a portfolio has a higher or lower beta than one, 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 of negative), this under- or outperformance of the market is called alpha.
Both alpha and beta are compared to a benchmark which in this case is the market. A fund which has a beta of one 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).
Smart beta strategies are driven by factors
Now let’s define factors. Factors are well understood and measurable investment ideas that explain share price behaviour over long periods of time, for example: VALUE, QUALITY or MOMENTUM. These factors are merely investment strategies that traditional active investment managers have employed for years and have historically delivered a return premium to the market.
As an example, the VALUE factor of a company measures how cheap a share is relative to others.
At the heart of it, smart beta has an active ideology (aiming to outperform the market) in how it delivers factors; however the major difference to active managers is that smart beta is implemented in a passive way. Let’s say it gives you the best of both worlds, active and passive.
The punches are in the weight
Smart beta funds are fundamentally different to vanilla index tracking funds in that they do not follow a market capitalisation weighting scheme. Instead, smart beta derives the weights of its stocks from alternative criteria. For example, assume Shoprite is 10% of the FTSE/JSE All Share Index, but a smart beta strategy only allocates a 5% weight to it. If Shoprite underperforms, this underweight generates outperformance versus the FTSE/JSE All Share Index. Likewise, if the smart beta strategy allocates 20% to Shoprite and it underperforms, the overweight results in underperformance. Basically, to create outperformance, you need to be underweight underperforming stocks and overweight outperforming stocks.
The chart below shows some of the ways in which index tracking funds can weight their stocks. We’ll explain each of these weighting schemes with examples.
Different weighting schemes
Market cap weighted
Market cap weighted indices rank and weight companies in the same order as their size on the relevant exchange. Size is measured by market capitalisation (number of shares in issue for the company x share price). The FTSE/JSE Top 40 index is a well-known example. Note that a market cap weighted index is not considered a smart beta fund as we are simply defining the market index by size.
As the name suggests, the index simply weights stocks equally, as opposed to ranking them by size. The simplest example of this is the Satrix Equally Weighted Top 40 Index fund where each of the 40 stocks has a 2.5% weight.
What does this mean? Let’s use the Satrix Rafi 40 Index Fund as example. All companies on the JSE are screened in terms of so-called fundamentals (sales, cash flow, book value and dividends) over a specified period. The 40 top-ranking companies with respect to these criteria are included in the index. This weighting scheme would typically produce smart beta funds which have value or quality characteristics.
Read also: SATRIX shares…why are you investing anyway?
Smart beta lets you choose what to invest in
Weighting stocks differently to the broad market index means you have a fund which is different from the market in terms of:
- Individual stock exposure
- Sector exposure (e.g. resources, financials and industrials)
- Factor exposure (e.g. momentum, size, yield and market sensitivity)
In the charts below, all the Satrix funds hold shares on JSE in them, but because of the different index rules, they differ dramatically from each other. Note the difference in sector and factor exposures.
Sector exposure of smart beta funds vs the Satrix Top 4
Style exposures relative to the All Share index
Most of the criticism levelled at index tracking focuses on market cap weighted indices, which simply mimic some of the larger indices, such as the FTSE/JSE All Share or the FTSE/JSE Top 40 Index. These index funds have been accused of being heavily exposed to overvalued stocks and less so to undervalued stocks. What smart beta offers a more sophisticated investor is the opportunity to invest in a different sector or factor exposure than is characteristic of the broader market cap indices. So 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, perhaps you would 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.
It‘s now possible to capture specific market exposure at a cheaper price without a performance compromise.
I told you we were going to dial it up. Stay with us over the next few weeks as we reveal even more about indexing.
As always and till next time, #JUSTSTART.
*Helena Conradie is CEO of SATRIX
*Satrix Managers (RF) (Pty) Ltd is an authorised Financial Services Provider and a registered and approved Manager in Collective Investment Schemes in Securities and an authorised financial services provider in terms of the FAIS Act. The information in this article does not constitute financial advice as contemplated in terms of the Financial Advisory and Intermediary Services Act. Use or rely on this information at your own risk. Independent professional financial advice should always be sought before making an investment decision. Collective investment schemes are generally medium- to long-term investments. Unit Trusts and ETFs the investor essentially owns a “proportionate share” (in proportion to the participatory interest held in the fund) of the underlying investments held by the fund. With Unit Trusts, the investor holds participatory units issued by the fund while in the case of an ETF, the participatory interest, while issued by the fund, comprises a listed security traded on the stock exchange. ETFs are index tracking funds, registered as a Collective Investment and can be traded by any stockbroker on the stock exchange or via Investment Plans and online trading platforms. ETFs may incur additional costs due to it being listed on the JSE. Past performance is not necessarily a guide to future performance and the value of investments / units may go up or down. A schedule of fees and charges, and maximum commissions are available on the Minimum Disclosure Document or upon request from the Manager. Collective investments are traded at ruling prices and can engage in borrowing and scrip lending. Should the respective portfolio engage in scrip lending, the utility percentage and related counterparties can be viewed on the ETF Minimum Disclosure Document. The Manager does not provide any guarantee either with respect to the capital or the return of a portfolio. The index, the applicable tracking error and the portfolio performance relative to the index can be viewed on the ETF Minimum Disclosure Document and/or on the Satrix website.
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