Should investors place their money in low fee funds that replicate the market such as Exchange Traded Funds (ETFs) or is it worth the paying the fees and premiums to invest in an actively managed fund and obtain returns that outperform the market? The answer to this question depends on whether investors believe that financial markets are efficient or not.
If financial markets are efficient, investors should not be able to outperform the market because the market price should actually reflect the real long-term value of the investment.
However, if financial markets are not efficient, investors and funds are able to outperform the market by investing in undervalued stocks and avoiding the overvalued stocks. This gives ordinary investors an interesting dilemma.
Alpha and Beta are financial indicators that allow us to benchmark and compare the performance of individual funds. Alpha compares the return of a fund with the return of the market adjusted for risk. In other words, Alpha is the active return of the fund vs the benchmark or market index. By way of example, if the fund returned 8% and the market index returned 5%, then the fund manager has added 3% of alpha (or value). As a rule of thumb, investors prefer to invest in fund managers with high and consistent Alpha values after any internal fees like MER, and ICRs.
Beta, on the other hand, looks at the volatility of the fund compared to the volatility of the market. A Beta of 1 indicates the fund has the same volatility as the market. Beta above 1 means increased volatility, while less than 1 indicates a fund that is less volatile then the market. Investors can use Beta to manage their risk preferences. For example, an investor wanting to reduce risk to preserve capital should look for investments with a low Beta value. Conversely, if an investor is bullish, they may seek an investment with higher Beta.
We have covered off index investing (or investing for Beta ) in a previous articlehttp://www.sophisticatedaccess.com.au/why-do-we-care-about-indices/.
Not often!
An analysis by Standards and Poor found that over a five year period a majority of major actively managed funds failed to beat the market benchmark after fees. While there are some funds that do outperform the market, plenty fail. Investors can lose in the long run because they are hit with high fees, leaving in some instances, fund managers the only winners in the long term.
ETFs, are therefore an attractive low cost option. ETF’s are designed to replicate the returns of the market, by replicating parts of the market. The most common ETF replicates the main indices by investing in stocks based on their market capitalization. However, this means that the fund over-invests in overvalued stocks and under invests in under valued stocks. Smart Beta Funds are designed to help eliminate these problems.
Smart Beta Funds follow indices but take a more active role in weeding out undesirable investments. A smart beta one might exclude an underperforming or overexposed industry, for example resource stocks. Another may only invest in high yielding stocks or remove volatile stocks. Smart Beta funds allow investors to adjust for factors influencing the market using a passive rule based strategy.
Betashares RAFI Index is a great example of a Smart Beta Fund in action. The fund invests in a wide range of Australian stocks, weighted in a way that is reflective of the company’s economic footprint rather than their market capitalisation. This has resulted a return of 0.5% above the ASX 200 rate, while still retaining the low fees associated with more common index based ETF.
According to Alex Vynokur, Managing Director of BetaShares, “Betashares provides investors with exposure to the performance of a range of indices that can help to build robust and diversified portfolios for investors. Our funds track indices across the Australian and US equities markets, as well as alternative markets such as commodities and agriculture. We believe a passive approach ensures investors get exposure to a broad range of securities and sectors within each asset class, eliminating company risk and allowing them to benefit from market gains over time.
He adds that ‘smart beta’ is an important evolution of the indexing process, as “issues have been discovered with market cap weighted indices in particular in recent years that have left investors overexposed to overpriced stocks”.
Betashares’ FTSE RAFI Australia 200 ETF and FTSE RAFI US 1000 ETF which trade on the ASX use fundamental indices rather than market cap weighted indices. Investors still get broad-based exposure to the Australian and US equities markets, while reducing exposure to stocks whose share price has grown out of sync with the other ‘fundamental’ measures of the company – sales, dividends, book value and cash flow. This approach has seen the RAFI Australia 200 index, for instance, outperform the S&P/ASX 200 over 3, 5 and 10 year benchmarks.
Smart Beta offers investors a simple way to tap into many of the benefits of a managed fund without having to pay the high management fees that are usually associated.
