Disruptive innovation: Lower cost outperformance

In The Innovator’s Dilemma, Harvard Business School’s Professor Clayton Christensen introduced the concept of disruptive innovation. “Products based on disruptive technologies are typically cheaper, simpler, smaller and frequently more convenient to use.” Welcome to smart beta.

Smart beta is getting considerable coverage in financial press but there are some misunderstandings about what smart beta is.

Smart beta is an index strategy that involves a methodology for construction that differs from traditional market capitalisation weighted benchmark indices. Examples of smart beta include equal weighting, filtering stocks using identifiable filters such as dividends or volatility and capping stocks. Smart beta indices are created using rules-based selection criteria with the intention of creating a portfolio that performs better than market capitalisation weighted benchmark indices.

The objective of smart beta is the same as that of active fund managers, to outperform the benchmark index. In financial jargon the return of the market or benchmark index is called ‘beta.’ Smart beta based funds are attractive compared to active funds due to:

lower costs;

explicit rules based methodology;

transparency; and

reduction of risks, including key man risk.

Most traditional index providers have had the foresight to create new smart beta indices in anticipation of increasing demand as smart beta funds replace active management around the world. MSCI, for example has created a range of factor-based smart beta indices such as the MSCI World ex Australia Quality Index. Some other index providers, such as Market Vectors Index Solutions have created indices that address stock concentration such as its Market Vectors Australia A-REITs Index.

Globally, smart beta is on the rise. ETFs that track smart beta indices have quadrupled since 20081. According to Funds Society,

“Investor appetite for tailored exposures not available via traditional market cap-weighted funds has accelerated in the past two years. Flows remained robust in 2014 after surging in 2013. Organic growth for smart beta is 18%, twice that of market-cap weighted equity ETFs.”

In Australia, smart beta continues to disrupt the funds management industry. It is easy to see why investors are adopting smart beta. A review of the most recent SPIVA® Australia scorecard shows that for Australian Equities, 74.9% of active managers underperform the standard market capitalisation benchmark index, the S&P/ASX 200 Accumulation Index. In International Equities,

“only around one-fifth of international equity funds enjoyed equal or higher returns compared with the S&P Developed Ex-Australia LargeMidCap … this observation has also been consistent over the past three and five years.”

In other words investors are paying higher fees to active fund managers who are picking portfolios that underperform the market capitalisation indices almost 75% of the time for Australian equities and over 80% of the time for international equities.

Smart beta ETFs are disrupting active fund managers due to being cheaper and easier to use and having transparency, a precise rules based approach and reduced risk. However, there are many different types of smart beta ETFs. Investors should understand the differences between the various types so they can determine if their investment’s beta truly is ‘smart.’

It’s time investors understood beta and how it impacts their investment outcomes so they can add alpha.