Passive funds have burgeoned into a range of styles and types, many of which were not around 20 years ago. The real interest today is in the more sophisticated, but largely misunderstood smart beta funds. But what exactly is smart beta?
Before we can explain smart beta, we need to define the investment terms beta and alpha. Simply put, beta is the return you as an investor receive simply by being invested in the market. For example, the return you receive by investing in the FTSE/JSE All Share index is a beta return. If you employ an active fund manager (one who studies companies and chooses a basket of shares for you) who gives you a return which is different to that of the market (either positive of negative), this under- or outperformance of the market is called alpha.
Alpha = Fund performance – market performance (beta)
Ultimately, alpha is the result of the manager weighting stocks differently to the index. For example, if Naspers makes up 10% of the JSE All Share Index, but the manager allocated only a 5% weight to it, and Naspers underperforms the index, this underweight creates positive alpha. Likewise, if the manager allocated 20% to Naspers and it underperforms, the overweight results in negative alpha. Basically, to create positive alpha, you need to be underweight underperforming stocks and overweight outperforming stocks.
Smart beta funds attempt to capture excess returns in a systematic way. The idea is to deliver a better return while taking on less risk than the JSE All Share index – at a lower price.
The accompanying drawing shows the different ways in which passive funds can weight their stocks. We’ll explain each of these weighting schemes with examples.
Market cap weighted indices are built using the top 15, 25, 40 or even 500 shares listed on a specific stock exchange. The companies are ranked and weighted in the same order as their market capitalisation (number of shares in issue for the company x share price) on the relevant exchange.
The simplest example of this is the SATRIX Equally Weighted Top 40 Index Fund. As the name suggests, it invests in the top 40 stocks on the JSE in equal weights as opposed to ranking them by market cap. Each of the 40 stocks receives a 2.5% weight in the equally weighted index.
What does this mean? Take the SATRIX Rafi 40 Index Fund. All the shares on the JSE are screened in terms of the so-called fundamentals (sales, cash flow, book value and dividend) of the last five years’ audited values. The 40 top-ranking companies with respect to these criteria are included in the fund.
The result of weighting stocks differently to the JSE is that you have a fund which differs from the JSE in terms of:
The sector and dramatically different factor exposures of the SATRIX Top 40, the SATRIX Equally Weighted Top 40, the Satrix RAFI 40 and Satrix Dividend Plus Index Funds are shown below.
Most of the criticism levelled at passive investments only focus on market cap weighted indices, which simply mimic some of the larger indices, such as the JSE All Share or the JSE Top 40 Index. These index funds have been accused of being heavily exposed to overvalued stocks and less so to undervalued stocks. Since it’s mostly a handful of very large cap stocks listed on the JSE that has boosted performance and kept the momentum running over the last year, there is an element of risk in market cap weighted index funds. Should the market fall, it will be the overvalued stocks that take the brunt of the drawback.
The debate around active versus passive investing has moved on. Instead, why not rather combine active and passive strategies? It‘s now possible to capture specific market exposure at a cheaper price without a performance compromise.
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