Investment research house Lonsec is of the view that Australia can expect the market for Exchange Traded Funds (ETFs) tracking ‘smart beta’ or non-traditional indices to grow in popularity in the near future, as increased risk aversion since the global financial crisis has resulted in greater demand for volatility targeted equity products.
ETFs tracking smart beta indices have gained in popularity, particularly in the United States market, but are relatively new to the Australian market. Smart beta indices are constructed using stock weights that are not proportional to market capitalisations, unlike traditional indices such as the S&P/ASX 200 Index. Two popular smart beta indexing strategies are fundamental indexing and low-volatility indexing.
Fundamental indexing weights stocks in proportion to their fundamentals, such as book value or earnings found in profit/loss and balance sheet metrics. Compared to a capitalisation weighted index, a fundamental index is tilted towards stocks that are cheap on such ratios; these are usually value stocks.
Low-volatility indices address the belief that low-risk stocks have similar or better returns than the market average with lower risk. Low-volatility indices use optimisation techniques to construct a portfolio with the lowest expected future volatility, or they adjust exposure to a market capitalisation weighted index to maintain a certain risk target.
Michael Elsworth, General Manager – Specialised Research, Lonsec advanced the premise that smart beta ETFs are on the rise because they represent a cost efficient way of investing in active management.
“Smart beta ETFs resemble passive investments, but the deviations from capitalisation weighted indices reflect active investment decisions,” Mr Elsworth said.
Surveys by the business school of the EDHEC-Risk Institute of France indicate that 40% of institutional investors are using alternative weighting schemes such as smart beta in their equity portfolios.
While these ETFs are cost efficient and target volatility, Mr Elsworth pointed out a number of risks investors need to be aware of:
- Some smart beta indices are overly simplistic and are therefore not designed to capture certain risk premiums efficiently.
- Past performance should be analysed over multiple economic cycles to ensure index construction rules are sound.
- Different indexation strategies mean that some fundamental indices might be biased towards financially distressed firms.
- Low-volatility indices can be less transparent and turnover can be high compared to other forms of indexing. They tend to take a one dimensional view of risk, ignoring expected return considerations.
The closest example of an ETF that tracks a smart beta index in the Australian market is the Russell Australian Value ETF (ASX Code RVL) that provides exposure to large cap ASX-listed securities that exhibit ‘value characteristics’ based on an internal Underlying Index called the Russell Australian High Value Index.
The findings come from Lonsec’s second ETF Journal, which was released late May 2013. It follows on from the inaugural journal published in December 2012, providing updates on recent changes to the Australian ETF market, Lonsec’s conclusions from recent ETFs sub-sector reviews, as well as topical issues that financial advisers and investors need to be wary of when considering ETF investment options.
Lonsec’s research process involves two different approaches: one for actively managed funds and one for passively managed funds such as ETFs. As the ETF market in Australia continues to experience significant growth, the Lonsec ETF Journal will provide financial advisers and investors with consistent and reliable information in relation to a range of important and contemporary issues.
