What Is Smart Beta?

Passive 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. But what exactly is smart beta?

Let’s start with alpha and beta

Before we can explain smart beta, we need to define the investment terms beta and alpha. Simply put, beta is the return you as an investor receive simply by being invested in the market. For example, the return you receive by investing in the FTSE/JSE All Share index is a beta return. If you employ an active fund manager (one who studies companies and chooses a basket of shares for you) who gives you a return which is different to that of the market (either positive of negative), this under- or outperformance of the market is called alpha.

Alpha = Fund performance – market performance (beta)

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 underperforming stocks and overweight outperforming stocks.

Smart beta funds attempt to capture excess returns in a systematic way. The idea is to deliver a better return while taking on less risk than the JSE All Share index –  at a lower price.

The accompanying drawing shows the different ways in which passive funds can weight their stocks. We’ll explain each of these weighting schemes with examples.

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.

2)      Equally weighted

The simplest example of this is the SATRIX Equally Weighted Top 40 Index Fund. As the name suggests, it 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

What does this mean? Take 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.

With 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 (e.g. resources, financials and industrials)
• Factor exposure (e.g. 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 Satrix Dividend Plus Index Funds are shown below.

Most of the criticism levelled at passive investments only focus on market cap weighted indices, which simply mimic some of the larger indices, such as the JSE All Share 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. Since it’s mostly a handful of very large cap stocks listed on the JSE that has boosted performance and kept the momentum running over the last year, there is an element of risk in market cap weighted index funds. Should the market fall, it will be the overvalued stocks that take the brunt of the drawback.

The debate around active versus passive investing has moved on. Instead, why not rather combine active and passive strategies? It‘s now possible to capture specific market exposure at a cheaper price without a performance compromise.

Disclaimer

Although all reasonable steps have been taken to ensure the information on this website/advertisement/brochure is accurate, Satrix Managers (RF) (Pty) Ltd does not accept any responsibility for any claim, damages, loss or expense; however it arises, out of or in connection with the information. No member of Sanlam gives any representation, warranty or undertaking, nor accepts any responsibility or liability as to the accuracy of any of this information. The information to follow 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. Please note that past performances are not necessarily an accurate determination of future performances, and that the value of investments / units / unit trusts may go down as well as up. A schedule of fees and charges and maximum commissions is available from the Manager, Satrix Managers (RF) (Pty) Ltd, a registered and approved Manager in Collective Investment Schemes in Securities. Additional information of the proposed investment, including brochures, application forms and annual or quarterly reports, can be obtained from the Manager, free of charge. Collective investments are traded at ruling prices and can engage in borrowing and scrip lending. Collective investments are calculated on a net asset value basis, which is the total market value of all assets in the portfolio including any income accruals and less any deductible expenses such as audit fees, brokerage and service fees. Actual investment performance will differ based on the initial fees applicable, the actual investment date, the date of reinvestment of income as well as dividend withholding tax. Forward pricing is used. The Manager does not provide any guarantee either with respect to the capital or the return of a portfolio. The performance of the portfolio depends on the underlying assets and variable market factors. All the portfolio options presented are approved collective investment schemes in terms of Collective Investment Schemes Control Act. The Manager has the right to close any portfolios to new investors to manage them more efficiently in accordance with their mandates. The portfolio management of all the portfolios are outsourced to financial services providers authorized in terms of the Financial Advisory and Intermediary Services Act, 2002. Standard Bank of South Africa Ltd is the appointed trustee of the Sanlam Collective Investments scheme.