Smart beta or ‘enhanced beta’ indices are constructed using stock weights that are not in proportion with market capitalisations.
Lonsec general manager, specialised research, Michael Elsworth said ETFs that track smart beta indices resemble passive investments – but their deviations from market capitalisation indices “reflect active investment decisions”.
Two popular smart beta strategies overseas are fundamental indexing and low-volatility indexing, according to Lonsec.
Fundamental indices are weighed in proportion to balance sheet metrics, book value and earnings. Stocks that are ‘cheap’ on such ratios are given a higher weighting.
Low-volatility stocks use optimisation techniques to put together a portfolio with the lowest expected future volatility.
Although smart beta ETFs are relatively new to the Australian market, they have gained in popularity overseas – particularly in the United States.
Forty per cent of institutional investors in France are using alternative weighting strategies such as smart beta in their equity portfolios, according to a survey by the business school of the EDHEC-Risk Institute of France.
But investors need to be aware of a number of risks related to smart beta ETFs, said Mr Elsworth.
Lack of complexity means some smart beta indices are not designed to capture certain risk premiums effectively, he said, while certain indices may end up being biased towards financially distressed firms as a result of their indexation strategies.
Past performance also needs to be analysed to ensure the index construction rules of a smart beta strategy are sound, he added – and low-volatility indices can suffer from high turnover and a lack of transparency.
