Can SA’s smart beta funds get smarter?
Passive investment managers have been introducing multifactor funds to deliver market-beating returns
SA’s smart beta providers are attempting to make their funds smarter by diversifying across multiple “factors” that have been identified as potential sources of returns higher than those the market can deliver.
Simple passively managed index-tracking funds invest in the shares that make up a market index, such as the all share index or top 40 index, in line with the size of the shares in the index. They deliver returns in line with the market after costs.
Smart beta funds track indices where the exposure to shares is tilted towards those that have characteristics of certain “factors” that have been identified to deliver returns better than those you can get from a vanilla index-tracking fund over the long term.
Academic research locally and internationally has identified these factors as value, momentum, quality, low volatility and size.
Factors that can deliver excess returns
Passive fund managers who offer factor- or style-based funds typically look to harness returns higher than the market from shares categorised in a style or factor by these characteristics:
Momentum: shares that have been performing well and are likely to continue to do so.
Value: shares that have low prices relative to the value of the company on measures such as book to price, book value, earnings to price, net profit, dividends or cash flow. Some funds focus only on dividend yields.
Quality: shares characterised by low debt, stable earnings growth and other “quality” metrics. The factor may be further refined into high profitability and low investment in other projects by companies that have high expectations for return on capital.
Low volatility: shares with lower-than-average volatility as measured by, for example, standard deviation.
Small cap: the shares of smaller companies relative to others listed on an exchange.
Locally, passive investment managers have introduced exchange-traded funds (ETFs) and unit trust funds that track indices constructed to deliver the returns these factors can deliver. These are referred to as single-factor funds.
But local managers, like their global counterparts, are also aware that investors in these single-factor funds may have to sit through long periods of underperformance because the factors typically deliver their best returns during different phases of the economy.
Local passive investment managers have therefore been introducing new “multifactor” funds, which diversify across the factors to deliver more consistent returns.
This week, CoreShares will convert its Equally Weighted Top 40 ETF into the Scientific Beta Multi-Factor Index Fund.
Its top 40 fund attempted to harness market-beating returns that can be delivered by mid- and smaller-cap shares by down-weighting exposure in the top 40 index to the largest shares in the index. The equally weighted fund assigned each of the 40 shares in the index 2.5% of the fund. The fund has, however, underperformed other top 40 ETFs over the past seven years, with the latest etfSA survey to the end of June showing its return over this period as just 6.74% a year, relative to the top 40’s 11.91%.
The new fund will track a multifactor index constructed by an indexation business attached to leading French business school EDHEC, says Chris Rule, head of product at CoreShares.
The EDHEC Risk Institute’s multifactor index includes exposure to six factors: value, momentum, small cap, low volatility and two measures of quality — high profitability and low investment.
In balloting its investors to change the mandate of the fund, CoreShares said investing in more than one factor will give investors more consistent returns and expose them to less timing risk than investing in a single “factor” or “style” strategy.
CoreShares is not the first manager to launch a multifactor fund. In 2013, Satrix developed a SmartCore multifactor index and on April 30 2019 it launched a unit trust that tracks the index, the Satrix SmartCore index fund. The index offers exposure to three factors: momentum, value and quality.
Fairtree launched a multifactor Smart Beta Prescient Fund exposed to the quality, value, momentum and volatility factors in equal weights in February 2016. The three-year average annual return to June is 7.56%, according to Morningstar.
Other managers, such as Stanlib and Alexander Forbes, have yet to launch a multifactor fund for individual investors but offer retirement funds and other institutional clients portfolios that are exposed to the quality, momentum and value factors, says Zack Bezuidenhout, the head of S&P Dow Jones indices for SA and Sub-Saharan Africa.
While it may make sense to diversify across the different factors and benefit from the exposure to each at different points of the economic cycle, managers are not in agreement on how best to blend exposure to the different factors.
CoreShares will equally weight its exposure to the six factors in its fund (16.6% each) and rebalance quarterly. Rule says CoreShares doesn’t want to overestimate its ability to time the factors.
Satrix’s head of portfolio solutions, Jason Swartz, told a recent Actuarial Society of SA investment seminar that factor timing is the holy grail of investing.
He said research shows that when the economy is contracting, low volatility strategies are successful, but when it recovers, value strategies work well. As the economy shifts into an expansion phase, momentum strategies tend to do well, but when it slows down again it is time to move from value into growth strategies.
The problem smart beta managers face is how to set rules to time the moves. Satrix has tested portfolios that tilted towards the best-performing factor or towards the factors with the best valuations (share prices relative to earnings), but the results were disappointing, Swartz says.
While equally weighting exposure to momentum, value and quality shares gives you good diversification, Satrix has decided to invest in the shares with the strongest displays of all three of the factors, Swartz says.
This is also the approach chosen by S&P Dow Jones for its S&P SA Composite Quality, Value & Momentum Multi-factor Index, which it introduced three years ago.
Bezuidenhout says exposure to multiple factors through this bottom-up, “stock-level” selection process may increase overall exposure to the desired factors when compared with allocating to multiple single-factor portfolios, what is known as a top-down “index of indices” approach.
Bezuidenhout says multimanager Analytics is using this index for its multifactor portfolios. The index has a 5.52% a year return over three years to the end of June and 15.38% a year over 10 years to the end of June.
Stanlib is using four rules to determine its exposure to the different factors, says Ann Sebastian, a portfolio manager at Stanlib’s Index Investments. It will consider the phase of the economy, the valuation of the shares representing the factor, the trend driving the factor and whether there is more opportunity to outperform by investing in the shares best representing a factor because they are well ahead of other shares on key measures.
Absa’s index fund manager, NewFunds, has three single-factor funds based on indices developed by Wits. In February, it introduced three multifactor funds, which aim to manage the volatility of the fund because there is a strong relationship between volatility and drawdowns (the amount by which your fund value falls).
The Absa NewFunds Managed Volatility Defensive, Moderate Equity and High Growth funds have different levels of exposure to the momentum and quality factors. They manage the risk by increasing or decreasing exposure to these factors relative to cash on a daily basis.
Len Jordaan, head of ETF distribution at Absa, says the aim is to manage the exposure to risky equities to avoid falls in value as these require even larger increases in value to recover to where you were initially.
It may be too soon to determine the success of many of the newer strategies, but the cleverer smart beta gets, the more it costs and the greater the risk of returns higher or lower than the market.