Many investors now accept the harsh reality that trying to beat the market is expensive, risky and time-consuming. They might achieve it but the returns are modest, compared to the risk involved with producing them, and the professionals’ time is probably better deployed elsewhere. Grudgingly they capitulate to the logic of index investing. Popular indices such as the FTSE 100, the 250 or All-Share are all based on market capitalisation—the weight of each stock on the index is determined by multiplying the share price by the number of shares outstanding. This is one way of measuring how much a company is worth.
For many academics this method of organising an index makes sense because of the “efficient market hypothesis”; that the share price of a company captures everything that is known about the business. The theory is that modern capital markets are so efficient that it is impossible for any individual to secure a sustainable, legal information advantage over other investors.
The problem with these indices is that they favour growth stocks—shares in companies whose earnings are expected to grow more rapidly than the market average but as a result are often overvalued. Stocks in some of these indices do not always represent good value, therefore—a company on the threshold of joining the FTSE 100 will, by definition, have a higher valuation than its rivals. In contrast, the company that is about to be ejected will have fallen on hard times and its value will be discounted relative to its peers. So companies joining an index will always be expensive and those leaving will always be cheap. The companies in the FTSE 100 will be the largest based on their share prices, but not necessarily by profits, asset value, dividends or revenue—all things you might want to take into account when buying a share. Would it not be a better idea if portfolios could be constructed on the basis of one of these fundamental measures?
Share prices are not correlated to the value of the company. Instead they represent the opinions and views of all market participants and that means they are subject to all the manias and fashions that dominate financial affairs. An investor buying into a conventional index fund will always have greater exposure to the popular sectors relative to the unpopular ones, and indices based on market capitalisation are always overexposed to expensive shares. These funds might deliver the returns of the market—otherwise known as the beta—but do they do it in the best way? The logic of smart beta is to design a fund that delivers the return of the market but in a way that removes the bias to expensive growth stocks.
No one really knows which shares are expensive or cheap at any given time. However, we do know two things. First, the market always overpays for growth, which is why value stocks outperform over the long term. Second, valuations always revert to the mean—in other words, if there is no fundamental change to the company in question, a change in share price will always correct itself over time.
Conventional index funds act as a voting machine, rather than as a weighing machine. That is what smart beta is really about: using some fundamental measure of the value—not affected by fads or fashions—of a company to determine how much of each stock to hold. Such models are blind to the data they use as they treat all dividends, net asset values, revenues and profits equally. But which measures should be used? Traditionally a company was assessed on its net asset value—the value of its assets minus its liabilities. But this is of questionable value in a fast changing world. The profit and loss account has become more popular in recent years There is a problem with that though, which is often summed up in this little ditty: revenue is vanity, profit is reality, cash is sanity.
Not all these numbers can be easily checked and may be subject to manipulation.
Since dividends are the cash paid out by a company to its shareholders, they have the merit of being independently verifiable. Even more important is that dividends account for most of the returns from equity investing. Active investors desperately seek capital gains, but studies by Barclays, Credit Suisse and others show the importance of dividends, reinvested dividend income and growth in dividend payments.
All these measures have merit but funds that use dividends have an advantage because that is what generates much of the long-term return. A smart beta fund removes human emotion and subjectivity, saves time (and so cost) because it doesn’t have to be actively managed, which benefits the investor and offers full transparency. Compared with conventional index-based funds smart beta funds remove the growth bias, may offer higher yield and experience less volatility.
But no one should expect any index fund to shoot out the lights. These funds are designed to give the returns of the index of the relevant asset class. Importantly though, they are cheaper to run, and reducing costs has the same effect for the investor as higher returns, but without the associated risk.
Crucially, with index funds you are only paying for beta: the overall return of the asset class. With active funds you pay more because the manager is promising to provide alpha (the ability to deliver greater returns than the market overall) but will usually fail to achieve even the beta after costs are taken into account. However, smart beta funds offer the potential to close the gap between the return of the fund and the return of the index—a less risky way of trying to beat the market.