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Smart Beta ETFs: Here’s What You Need To Know

Neha Gupta

Smart Beta ETFs are some of the most dynamic and lucrative investments, available to ordinary investors looking to diversify an investment portfolio. Not only do they deliver superior risk-adjusted returns, but focus on areas of the market that can be exploited for maximum returns.

 

What is a Smart Beta ETF?

Simply put, a smart beta ETF is an exchange-traded fund that uses alternative index construction rules, instead of the cap-weighted index strategy. These type of traded funds utilize both active and passive methods of investing, to maximize income and shareholders returns, while at the same time minimizing risk.

High returns is synonymous with smart beta ETFs because of low costs of operations, given that managers don’t play an active management role. Investors are slowly turning their attention to smart beta ETFs because actively managed ETFs have become costly in the low-interest rate environment.

Lower portfolio risks, as well as optimal dividend returns, also make smart beta ETFs desirable for income-focused investors.

Passive strategies continue to outperform active management strategies in seven out of 11 markets in Asia. Despite the popularity growth, Asia-Pacific region accounts for just 2% of smart beta assets under management and 12% of the number is on smart beta ETFs.

The primary goal of smart beta ETF is to increase diversification in a more cost-effective manner. These types of investment tools also seek to address some of the inefficiencies synonymous with market-capitalization weighted benchmarks.

 

Smart Beta ETF Characteristics

Equally Weighted

Instead of paying more attention to price and capitalization, as is the case with other traded funds, smart beta ETF s consider all factors when it comes to weighing indexes.

 

Fundamental Weighing

Companies listed in smart beta ETFs are selected and weighted based on total earnings and book value, rather than market cap.

 

Low Volatility Indexes

These types of smart beta ETFs focus on indexes with low volatility. Indexes are also weighted based on their historic volatility. Low volatility smart ETFs focus more on risk reduction to maximize returns.

 

One example of a smart beta ETF in Singapore

Lion-Philip S-REIT

Lion-Philip S-REIT is one of the smart beta ETFs receiving a lot of media coverage in Singapore. Launched jointly by Lion Global Investors and Philip Capital Management, the S-REIT garnered an initial asset under management of more than S$100 million when it went online.

The new ETF is designed to appeal to investors looking to participate in the growth story of Singapore’s REITs in a low cost and transparent manner.

“We have been strong advocates of Singapore REITs since 2002, and our investments in this sector have served our government pension, global institutional, and retail clients well. We are honored to work with Lion Global Investors, and this collaboration marks a new era for two local management firms to introduce innovative products to serve better the investment needs of clients,” said Jeffery Lee, CIO of Philip Capital Management

The ETF is one of the very first exchange-traded funds in the world, to focus solely on Singapore Real Estate Investment Trusts. The approach does not come as a surprise given the exceptionally high yields synonymous with REITs in the country.

REITs in Singapore are exempted from the 17% corporate tax which makes them popular investment vehicles for investors seeking high and stable dividend yield.

The Lion Philip S-REIT Exchange Traded Fund invests in 23 Singapore REITs. Given that, the REITs are selected based on their weight rather than a market cap, the maximum weight of any constituent is fixed at 10%. If a REIT exceeds 10% in weight it is always rebalanced to within 10%.

Lion Philip S-REIT is a passive ETF, which means a fund manager does not actively manage the fund but simply tracks an index. The smart beta ETF tracks the Morningstar Singapore Yield Focus Index. The index uses a proprietary three-factor investment methodology that emphasizes business quality, financial health, and dividend yield.

 

Risks Associated With Smart Beta ETFs

The fact that smart beta ideas take advantage of temporary anomalies and inefficiencies in the market means they can be costly, whenever the inefficiencies correct themselves. Compared to traditional index funds, smart beta ETFs tend to be costly and exhibit extended periods of underperformance.

 

Higher Risk

High returns on offer with Smart beta ETFs comes with a higher overall risk as well. Overweighting on a specific sector could expose investors to a higher degree of risk should something go wrong. Smart Beta ETFs are designed to perform in certain market condition. Whenever market conditions shift in another direction, investor’s risk is always exacerbated which may lead to increased losses.

Smart beta ETFs are normally hawked as instruments that will outperform the market by capitalising on market inefficiencies without taking into considerations the costs and risks involved.

 

Higher Costs

Smart Beta ETFs come with much higher annual expenses when compared to traditional index funds. While they don’t incur management costs, they carry higher expense ratios, portfolio turnover, and rebalancing costs.

 

Underperformance

The need to rebalance a smart beta ETF to ensure all constituents trade within set weighted limits leaves them vulnerable to extended periods of underperformance. Smart Beta ETFs will often trail benchmarks because of the rebalancing act.

 

Crowding

The low volatility environment where smart beta ETFs have thrived in the past is slowly fading away as more money continues to chase a strategy. The performance gap, when compared to traditional benchmark indexes, is slowly narrowing as more money enters the space leading to overcrowding.

Amidst the disadvantages, Smart Beta ETFs still provide investors a way of diversifying their portfolio and earning a significant amount of return by taking advantage of market inefficiencies. However, caution should also be taken given the increased risk that could come into being should on market conditions shifting the other way.

 

This article first appeared on ZUU online.

ZUU online is an Asia-based financial education online portal. Founded in Japan by Kazumasa Tomita, a former private banker at Nomura Securities, the portal seeks to fill the information gap between institutional research houses and the private investor.

(By Neha Gupta)

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