Index tracker: but cap-weighted indices might not be the best approach © Kiyoshi Ota/Bloomberg

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In 2002, quantitative analyst Rob Arnott set up Research Affiliates to try to offer alternatives to the standard cap-weighted benchmarks.

Mr Arnott’s key concept was “fundamental” indexing, whereby the companies in the index were weighted according to various financial metrics, such as earnings per share. Because this automatically overweighted companies with healthier finances, he claimed, it should outperform the traditional benchmarks that allocated capital purely on the basis of size.

Many critics argued this was merely a value strategy in fancy wrapping, rather than a unique insight into the challenges of index creation, but this did not stem the rise of what is now usually called “smart beta”. This catch-all term refers to any index strategy that deviates from the cap-weighted methodology, usually in an attempt to outperform that benchmark in a systematic way.

Whether Mr Arnott’s was a systematic value strategy might be open to debate, but the disadvantage of his method, and other so-called factor-based strategies, such as momentum or low volatility, is that none will work in every market condition. Low volatility, for example, might be a good idea when markets perform as they did at the start of the year. But when markets calm and volatility disappears, the strategy would no longer be worth the fees.

In response, providers are coming up with a variety of strategies that combine these factors, in an attempt to offer something that will be valuable in all market conditions.

Investors are pouring money into these and other smart beta products, looking for a compromise between the low-cost, cap-weighted giants and the more expensive active strategies.

“These strategies already existed,” says Chris Mellor, executive director for equities product management at Source, an ETF provider. “They’re pretty much as old as investing — we’re not trying to reinvent the wheel.”

However, although fund managers may have offered value, quality, momentum strategies for many years, they have always fallen into the active category, assuming that it takes expensive human judgment to identify these factors. Where ETF providers hope to have an edge is by building and tracking indices based on these factors.

“What’s really new is the way investors are able to get access to these factors in a systematic way without paying the fees for active management,” says Mr Mellor.

Investors are responding enthusiastically, particularly in Europe. According to a survey of asset owners commissioned by index provider FTSE Russell, 79 per cent of European asset owners have evaluated smart beta, somewhat ahead of North Americans, of whom 61 per cent had looked at the concept.

Of those using smart beta products, 55 per cent had allocated a tenth or more of their equity portfolio to these strategies, up from 38 per cent a year earlier.

This money is coming at the expense of vanilla ETFs tracking traditional benchmarks and active managers.

Matthieu Guignard, global head of product development and capital markets at Amundi ETF, Indexing & Smart Beta says pension funds are switching from traditional passive and traditional active to smart beta. Those switching from traditional actively managed funds were disappointed with performance and looking for lower fees, he says.

Amundi’s multi-strategy ETF is available at a cost of 40 basis points, more than the standard for traditional ETFs, but considerably lower than the typical fees for active management. The product was developed in response to client demand, says Mr Guignard, adding that a single large pension fund suggested the idea.

Rolf Agather, managing director of North America research for FTSE Russell, says smart beta indices have given asset owners and their consultants more choice and flexibility in the tools available for constructing portfolios.

Such strategies, along with most money in smart beta, are all equities-based. But just as fixed-income ETFs gradually followed the growth of equity ETFs, the fixed-income world is coming around to the idea of smart beta.

Traditionally bond indices are constructed on a cap-weighted basis, which offers more exposure to issuers with more debt. The alternative, as offered by Pimco’s Gladi series, is to develop a rules-based system that takes account of the issuers’ underlying financial health, such as a country’s predicted GDP growth or the free cashflow of a company.

Lombard Odier now offers four fundamental fixed income ETFs through ETF Securities, focusing on global government bonds, global corporate bonds, European corporate bonds and emerging market local currency bonds.

Kevin Corrigan, head of fundamental fixed income at Lombard Odier, says it sees no advantage in using ETFs over another structure, other than giving the company “access to another investor-base”.

Given what he describes as the industry trend for more efficient investment, the growth in smart beta is likely to continue. Provided, that is, that the products can deliver the risk-adjusted results.

Letters in response to this report:

Exchange traded fund providers should be treated fairly / From Bruno Poulin and Antoine, Moreau

Professionals are dragging their feet over smart beta / From Matthew Parden

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