There is a large body of research shows that a only a small number of funds beat the market over the long run after fees. It has become common knowledge that investors should just track the market by buying index funds.
Traditionally stocks in the index funds are selected based on their size. The larger the company, the greater weight it has in the index fund portfolio.
We think this is the key factor that made index funds so successful. The stronger companies will remain the portfolio and allocation will increase as they become more successful. The weak companies weights will be overtaken by more successful candidates. In finance this is called survivorship bias.
Selecting stocks based on its size is not without flaws. It can lead to overly concentrated portfolio with benefit of diversification.
For example the ASX 200 large cap includes 200 largest listed Australian companies. However the banking and mining sectors dominate more than 50% of the portfolio. The top 10 positions in the fund can make up to half of the fund as well with positions across all 4 major banks. We would argue that there is limited benefit in investing in all 4 big banks as they essentially trade as one position.
One key limitation or from diversification perspective an advantage is that most of these funds are listed in the US. There are limited choices in Australia.
What is smart beta?
Smart beta ETF is the latest evolution in listed ETF space. Unlike traditional index funds such as S&p 500, DAX or FTSE where market capitalization is the only criteria. Stocks in the smart beta ETF’s are based on a custom benchmarks where other investment factors are used in creating the portfolio.
Example of these factors include price to book, price to earning ratio, dividend yield, balance sheet ratios such as low leverage companies or other investment characteristics that make up value or growth stocks. There are even benchmarks which only include companies that are buying back their own stock.
From portfolio construction perspective, some smart beta funds avoids the concentration risk by simple decision rules such as all positions will have the same weight in the portfolio with quarterly rebalancing or stocks selected that are low in volatility.
Smart beta funds
We have to caution that some funds are created by simply data mining historical return data and finding what worked in the past and extrapolating into the future.
Past performance is not an indication of future performance. Only because a portfolio using these factors has performed well in the past does not mean it will work in the future. All investment should be made using judgement and logic.
Our investment approach is always look if the current trading price reflect the fundamental value. If it is overpriced given the risk, we will pass and wait for the next pitch.