Cheaper, better, beta?

Smart beta claims to offer above-index returns at passive prices. Emma Wall finds support for the strategy growing

Want to have your cake and eat it too? The latest investment fad insists you can have the best of both worlds – the returns of active investment, at the cost of a passive strategy. Smart beta, as well as giving cause for 101 headline puns, is being hailed as the answer to many a wealth manager, financial adviser – and pension trustee’s dilemma. Facing downward pressure on fees? No problem – use a blend of cleverly tweaked tracker funds and as the portfolio outperforms the benchmark and justifies you your own costs and charges.

Pensions minister Steve Webb has confirmed that from next April there will be a cap on pension charges of 0.75 per cent a year. Since the cap was initially proposed there has been a backlash among the pensions industry – AllianceBernstein argues that more expensive investment strategies will incorporate more investment sophistication, and features designed to get a better risk/return trade off, while Schroders says a price cap could place even further downward fee pressure on the investment component of the default; unsuitable for DC schemes where it is real outcomes that matter, rather than relative performance.

One solution being proffered up to bridge the void between performance and cost is smart beta.


To believe in the smart beta proposition, reads the Towers Watson publication Understanding Smart Beta, one must first accept that there is a wider framework than the narrow definitions of alpha and beta that classic finance theory puts forward. In this framework, somewhere between alpha and beta, lies smart beta.

The theory at least stands up. Normal tracker funds, although cheap, can be inefficient.

“According to the efficient market theory, each stock price incorporates all available information and is accurately priced, but academic research has shown markets are not always efficient,” says Nest chief investment officer Mark Fawcett.

“This leads to market capitalisation indices being biased towards price momentum and in market bubbles this can lead to a misallocation of capital, with the most highly valued companies contributing too much to a particular index.”

Smart beta claims to be able to add an edge – all the while complying with new cost regulations for default funds. Aon Hewitt senior partner John Belgrove says that smart beta is perfectly positioned cost wise between traditional passive tool and actively managed funds.

“The Total Expense Ratio on smart beta funds tends to be somewhere between that of actively managed funds and that of traditional passive funds: we have seen competitive pressures acting to reduce smart beta TER.  We do see this trend continuing and this might well bring them more to the fore with investors,” he said.

Smart beta is not the only option available to DC schemes looking for low cost solutions however.

“Increasing price pressure will impact some actively managed, diversified default fund options. This may result in an increase in smart beta,” admits Aegon investment director Nick Dixon.

However as Dixon points out there are other ways of giving low-cost exposure to investment markets and addressing some of the conventional index shortfalls.

“The important aspects will be demonstrating value for money and making sure the default fund addresses the primary needs of investors,” he adds.

Barclays Corporate & Employer Solutions head of DC investment consulting Lydia Fearn agrees that smart beta is not a panacea for the cost crisis. She points to the number of factors that need to be considered before including smart beta within a default investment strategy.  In particular, the implementation costs of such a strategy can be high due to the potential for more regular rebalancing. This may cause problems if transaction costs are included within the charge cap in due course as turnover tends to be higher than in a regular passive portfolio.

And this is likely – the DWP has said it will review whether under the bonnet charges need to be included in the cap once it is implemented.

“As smart beta strategies are trying to break the link between market prices and index weights, they typically hold larger allocations to smaller companies and this can impact on liquidity within the strategies and potentially create a reduced investment capacity,” Fearn warns.

You may as a result also end up with far great exposure to a certain individual listing than initially intended – especially with several smart beta strategies run simultaneously.

Smart beta is not just appealing from a price point. Belgrove points out that some smart beta indices are set up with the aim of lower volatility and these characteristics might well be attractive to trustees looking to provide good long term returns whilst, at the same time, managing the volatility that members see in their pension investments.

Dixon says that promising a better risk/return profile that more traditional passively managed funds, while keeping costs fairly low, means smart beta seems to have a no-brainer appeal in the default fund market.

“However, it is important that investors understand the default strategy’s aims and what their savings are invested in,” he warns. “Some smart beta strategies aim to give exposure to alternative assets or use more complex techniques, which may make them less appealing as default fund options.”

He said that there was greater potential for risk-target and risk managed funds – some of which may use smart beta techniques.

“Risk-target funds more clearly address fundamental savings needs like value, ease, long-term growth, and risk management,” he adds. “Our platform default fund, the MI Workplace Savings fund, is an example of this, targeting a medium appetite for risk and including a risk management safeguard that aims to reduce the impact of sharp market falls.”

It is worth remembering that despite all the clever tinkering even smart beta isn’t clever enough to make all the investment decisions for pension providers.

Morningstar Investment Management managing direct Simon Ewan says that timing is everything with smart beta investment, even more so than with active management.

“Smart beta strategies vary considerably in performance depending on when you invest. It is not enough to simply choose not to outsource stock selection – you still have to time the market well if you want positive returns.” He adds: “A good active manager will always justify their fee.”

The number of variables can also overly-complicate smart beta strategies, and uninitiated investors may be put off by periods of market underperformance – if they are expecting passive investment, returns that do not match the index may crack confidence.

JLT Employee Benefits director of manager research Peter Martin says smart beta as a concept needs to be more clearly defined. 

“There are a number of strategies and approaches across asset classes which use the banner of ‘smart beta’ but are fundamentally different in approach,” he said.  “We need a clearer consensus and greater granularity. Perhaps then we can then focus on the merits of each strand and add value to clients over the long term.”


Beta is the return provided by the underlying market as oppose to the added value that a manager adds through stock selection. A normal tracker fund provides a return equal to the market beta.

Smart beta helps investors overcome perceived flaws in regular market trackers by weighting an index in a way other than market capitalisation. Doing this can create significantly different returns – and only requires “active” initial choice, rather than the constant tweaking and ongoing cost associated with active management.

Take the FTSE 250 index for example. Investors – retail and professional alike – associate the FTSE 250 index with mid-sized UK companies, and would buy an ETF tracking the index for that exposure. But the FTSE 250 also includes investment trusts, in fact a whopping 15 per cent of the index is actually closed-end funds – which are made up of all sorts of underlying holdings which have nothing to do with the UK mid-cap sector. Recent studies by Morningstar revealed that if you siphoned off the investment trusts over the last 10 years, the FTSE 250 has lagged the FTSE 250 ex-Investment Trusts by 19 per cent on a cumulative basis, or shy of 0.70 per cent on an annualised basis.

Similarly, indices can be weighted by the size of the dividend each component pays, by which stocks have a competitive advantage over their peers or to smooth volatility, as well as other fundamental or macroeconomic risk factors.

“Smart beta is about trying to identify good investment ideas that can be structured better than market capitalisation weighting, whether that’s by improving existing beta opportunities or creating exposures or themes that are implemented in a low cost, systematic way,” said Nest chief investment officer Mark Fawcett.

Much confusion arises when it comes to defining smart beta. Morningstar for example would classify the FTSE 250 ex Investment Trusts as a “screened index”, where many other data providers classify this as smart beta.

A paper by Towers Watson describes smart beta implementation as about trying to identify good investment ideas with better structure, “whether that is improving existing beta opportunities or creating exposures or themes that are implementable in a low-cost, systematic way”.