No more Smart Beta
Updated: Apr 25, 2020
Index investing has a purpose, it allows you to buy the entire market in one product and therefore your investment performs as the market does. This allows an investor to produce market returns in a cost effective and well diversified portfolio, which over a long-term time frame over 90% of professional investment companies cannot beat. 
Over time, ETF’s have become increasingly narrow and specific. ETF providers have entered the market in mass, developing new ideas on how they can bring more options to investors portfolio’s. You can now find sector specific, commodity specific and also the much newer concept of Smart Beta ETF’s.
Smart Beta ETF’s have been around since pretty much the inception of ETF’s but have steadily increased in popularity over time.
According to Investopedia the definition of “Smart Beta” is as follows: 
So in a nut shell a Smart Beta ETF involves passive investing in an index combined with the active involvement by the ETF issuer to adapt the ETF to meet specific sets of rules. This option usually comes with a price premium compared to your started ETF's as it requires more time and additional transaction costs in the process of delivering and maintaining the product on the side of the ETF provider.
In the process of putting together one of these ETF’s the ETF issuer will create a transparent set of rules which governs how they select stocks for their product. Some common considerations for a Smart Beta ETF involve selecting shares based on volatility, liquidity, quality, value, size, dividend yield or momentum. There are also many funds adjusting the usual market cap weighting of shares in the index into an equally weighted or a capped weighted index. This means that a ceiling is put on a shares contribution to the index that the ETF tracks. The level of involvement varies from product to product and will always depend on the set of rules which govern the ETF.
An investor may invest in a Smart Beta ETF for one of the following reasons:
· To outperform a specified benchmark over time
· To decrease volatility
· To reduce risk
· To increase the exposure of a certain type of fundamental or investment category to their portfolio
In the South African ETF market we currently have about 59 equity focused ETF’s available for investment. Of this I would categorise 31 of these funds as Smart Beta ETF’s. Please see the following ETF Glossary for a list of these funds – ETF Enthusiast ETF Glossary.
Let’s take a look at a comparison in the South African market in where we compare a Top40 fund with two other Smart Beta variations:
As you can tell by each ETF’s top 5 constituents these three ETF’s are significantly different. With one simple rule overlaid onto the index based on weightings these three ETF’s will now produce very different returns. The two Smart Beta options also cost the investor a bit more money every year with the differences in their Total Expense Ratio’s (TER).
Personally I have owned the CoreShares Equally Weighted Top 40 ETF (CSEW40) since I bought my first ETF in 2015. In this 5 year time frame I am sad to say that the CSEW40 has under-performed the top40 index. Net of fees the investors in the STX40 have been rewarded with double the return over the last 5 years than those invested in the CSEW40.
The reason for this difference in performance is solely due to some of the bigger shares in the Satrix40 contributing to most of the positive return. Naspers has produced a return of 272% in the last 5 years and has now become by far the biggest share on the JSE by market cap.
Now I am not naive enough to think that just because one of my primary ETF investments have under-performed means that the ETF is doomed and broken, but this was the starting point to me beginning to look at Smart Beta ETF’s through a more critical lens.
The short time that I have spent in the market learning about investments and investing plenty of my own money has led me to the conclusions that most of the time the simplest approach is usually the best approach. In my opinion Smart Beta ETF’s are a move away from the inherent simplicity of ETF investing and a big step in adding more complexity to the equation.
Indexes are not a fixed event which we invest in at a set point in time with a prescribed set of shares that never changed. Indexes vastly change shape and constituents over a long time frame, smaller shares can go on unbelievable runs and become dominant businesses which have a major weight on an index. Apple, Amazon, Google and Facebook are all shares that are at the top of the S&P500 index, if we look back 7 years ago it was only Apple who was in this list of top 6 companies in that index. Over a ten year period the JSE top40 has also considerably changed shape where 40% of our top 40 companies in the index have changed. 
In the CSEW40 ETF the shares are rebalanced back to the 2.5% weighting each quarter, this process takes away the indexes natural ability to change shape and drive return based on individual share runs. Now this doesn’t mean to say that this ETF won’t eventually produce returns greater than the standard top40 index, it may well do so, but I have begun to ask myself why am I trying to outperform the standard top40 index. This goes against the basic fundamental strategy of ETF’s which is perform as the index does. If I am worried about single stock risk due to the weight of Naspers in my portfolio then surely the index I am investing in is not broad enough?
We are now at the point where in order to create an ETF the ETF issuer is even creatingmore and more niche indices. Ever heard of the Absa Wits Risk-Controlled SA Low Volatility Index or Absa Wits Risk-Controlled SA-Momentum Index? These are the indexes that the NewFunds Low Volatility ETF and NewFunds Equity Momentum ETF track. I don’t feel that narrowing down our investments to this degree is a wise investment decision.
The same goes for investing in particular sector of the market particularly property ETF’s which I have been invested in in the past. If I invest in an appropriately diversified and global ETF, my exposure any sector is as it naturally occurs within that index. Remember that purpose of ETF investing that I mentioned at the beginning of this post. The purpose is to perform as the entire market performs. It therefore does not make sense to me to increase any specific sector into my portfolio, this actually increases risk and moves me away from that purpose I am trying to achieve with passive investing.
When ETF’s were created by jack bogle the intention was clear. These product need to be as broad as possible, “whole market products” and not as Jack Bogle calls it “fruit and nut ETF’s”. See the below video for more on his opinion:
I do think the growth of Smart-Beta ETF’s is a net positive for investors, it has increased investor options and has brought more competition into the industry, therefore bringing down fees. But I do think that the average investor’s behaviour is rather poor. There is too much activity going on in one’s investment portfolio in the course of the year, and the biggest problem that I have with investing in Smart-Beta products is that it will only increase investor activity within their portfolios. This activity will be amplified as investors go through patches of over/under performance. I am sure the vast majority of investors in the CSEW40 would have felt that their money is better off in the generic alternative, and many would have already made the switch away from it. Long periods of under-performance can do considerable damage to an investor’s portfolio when the investor reacts by selling their investments and trying to time their entry back into the market. Think about an investor buying a value ETF and trying to time their exit when they feel the market no longer represents a value market and moves that money into another smart beta factor like momentum. The investor will get this wrong way most of the time.
In summary, given we have decided to contribute part or maybe our entire investment journey to these passive products, in order to fully utilise these products we need to play our part as passive investors. This means setting ourselves up for success with a simple investment strategy, and then making very few decisions from there. I feel that one or two (at max) single diversified global ETF’s is all that is needed to encapsulate the investable world available to us. This is what ETF’s were originally intended for and how I feel they are best utilised.
 Based on the latest SPIVA report 91.03% of fund managers cannot beat the S&P South Africa DSW Index - http://ow.ly/433L50riChY
 Full Smart Beta Investopedia definition – https://www.investopedia.com/terms/s/smart-beta.asp
 For references to this performance comparison please see each ETFs factsheet; Satrix 40 – https://satrix.co.za/media/30879?inline=true CoreShares Equally Weighted Top 40 –
 By “broken” I mean that the methodology is floored
 Over 10 years, 40% of shares in the JSE’s Top 40 have changed - http://bespokeza.co.za/over-10-years-40-of-shares-in-the-jses-top-40-have-changed/
 Increases risk by adding exposure to a particular sector above what it naturally occurs in the market