The growth of smart beta investment in Europe

The growth in popularity of smart beta investment amongst European investors continues.

According to a recent survey by exchange-traded funds (ETF) Invesco PowerShares, users of smart beta products currently have 13% of their total assets invested in smart beta strategies.

This compares with 8% in 2016, and it is expected to increase to 23% over the next three years.

Key findings

Invesco PowerShares highlights a number of key findings in “Smart beta strategies: more bricks for portfolio building”. These include the following.

• Short-termism is on the rise. More than three quarters of respondents experience pressure to deliver portfolios that perform strongly in a shorter time frame.
• Demand for monthly portfolio performance reviews is surging, too. Professional investors are increasingly turning to smart beta as an approach to achieving their clients’ investment objectives in this environment.
• Low yields, the need to find value, and the correlation of assets are the most significant challenges identified by professional investors.
• We are seeing increasing sophistication amongst smart beta users. As the length of their investment in smart beta increases, they become more expert and take a more sophisticated approach to investing. There is a noticeable shift from traditional asset-based allocation to more risk-based allocation.
• The strategies that users are looking for are changing. Looking at retail professional investors, in particular, momentum, quality and multi-factor strategies are booming, with usage of these three strategies almost doubling from 2016 to 2017.
• Although most users are still focussed on equity asset classes, there is growing interest for smart beta in fixed-income. Well over half of institutional investors would consider allocating to fixed-income smart beta strategies.
• User satisfaction is extremely high. Some 97% of users report that smart beta allocations are meeting or exceeding expectations, and three out of four plan to increase their allocations.
• There remains entrenched scepticism amongst non-users, over half of whom explain their reluctance as coming from a firm belief in active management.

400+ investment professionals consulted

More than 400 managers, chief investment officers, fund selectors and fund analysts European markets were consulted in the survey. Only around one in five of the 400+ respondents, from the UK, Germany, Italy, Switzerland, the Netherlands and France, do not yet use smart beta.

But just what is smart beta? Who uses it and how? What are its attractions and drawbacks?

Arne Staal is recognised as a smart beta expert at recently merged investment firm Aberdeen Standard. The concept has been around a long time, he states. It enables investors to, for example, undertake equity investment in a smarter way than through traditional benchmark indices.

Arne Staal, courtesy of Aberdeen Standard

Smart beta evangelists

Smart beta evangelists advertise it as having potential for market-beating returns generated with full transparency at low cost, he says.

The reality of smart beta investing is much more complicated, however, and investors should approach it in the same ways as they would an active fund manager; understand the investment thesis and focus on delivered investment results rather than theoretical indices.

It forms one part of overall asset allocation. “From a multi-asset allocation fund perspective it offers some very good building blocks in large portfolios,” says Staal. “The percentage allocation made to it will depend on what kind of manager the investor is.”

Identifying market styles

“Smart beta is an investment approach that tries to identify within a given market certain styles characteristics of individual companies and how they will perform relative to one another,” explains Alistair Jex, head of bespoke portfolio management at Coutts. “The classic examples are growth, value and momentum,” he adds.

“You are not looking to outperform an index, simply to filter out the companies that display sensitivity to a particular style.”

Mike Paul, head of Invesco PowerShares EMEA, concedes that smart beta is no panacea, but it does have the potential to help with major and emerging challenges such as low yields and finding value at a difficult time for professional investors.

Changed landscape

Despite his expressed concerns, Staal acknowledges that the increasing availability of low cost, commoditised algorithmic investment strategies undeniably changes the investment landscape permanently.

Those who have adopted it are comfortable with it but there has not (yet) been a huge shift toward wholesale adoption of different smart beta styles, he notes.

Most interest so far has been in low volatility smart beta exposures. A choice to make a smart beta allocation is an active one, he cautions.

“Things with the same label will not perform in the same way. Different strategies will do different things in different ways. The smart beta label covers a broad range of investor strategies.

We believe

“We believe in the tool. It can bring diversification benefits and new ways to express economic views, but you need to understand the label. But on its own it is not enough.

“I'd be positive on the area under survey but I'd be a bit more conservative in terms of how quickly I'd use the full range off smart beta approaches available and how rosy the future looks,” he adds.

Does it actively present any dangers? “Smart beta is rules-based investing capturing such themes as low-risk, value, quality and growth,” says Staal. All investment rules fail at some points in time.

Eyes on the long term

“Smart beta should not be tactical. It should be used for through the cycle investment with sights firmly set on the long term.

“Investors need to understand their investment and their position and to have consciously decided to invest in that position rather than naively follow a label.

How does an investor invest in smart beta? For many investors, exchange-traded funds are the first port of call to gain smart beta exposure. But they do have shortcomings, he advises.

ETF follow indices that in many cases are not necessarily designed by investment experts but by data providers. The rules applied can be overly restrictive because of the liquidity and transparency requirements of an ETF. It is not clear who takes responsibility for the investment outcome (other than the end user).

The Staal smart beta mantra

• Smart beta is a suitable tool
• Know and understand what you are buying
• It is not always obvious

The appeal of smart beta

In a recent thought piece targetted directly at professional investors and their advisers, global investment firm Schroders explains that smart beta appeals to many investors drawn by its claim of low fees, transparency of return sources, and attractive historical performance.

This is an impressive package, it says. But sophisticated investors are increasingly aware that simple smart beta implementations can also suffer some serious drawbacks.

Its suggestion that other options need to be examined to address those drawbacks and construct 'multi-factor portfolios' clearly echoes Arne Staal's description of it as one building block in multi-asset allocation.

Eggs and baskets

Or, as Alistair Jex of Coutts sums it up: You should not put all your eggs in a single investment basket. Diversification is central to portfolio construction. Smart beta is just another building block used in the process.”

“Analysis of investment returns over a number of years has shown that adopting a single style of investing view often does not work. Investment styles are cyclical but can continue to perform strongly over many years irrespective of performance differentials..

The last word

The last word goes to Mike Paul of Invesco PowerShares. “Smart beta has been one of the definitive market trends of the past decade, and we believe that smart beta strategies play an increasingly important role in ensuring investors achieve the outcomes they seek.

“If the market is the best benchmark for product excellence, then it is clear that smart beta is set to play an increasingly central role in the future of the European asset management sector,” he concludes.