Smart beta indices combine the best features of passive and active investing, or so it seems. Although not a new concept, investors would be hard pressed these days to avoid structured products linked to indices which call themselves 'smart beta' or are labelled 'scientific beta' or 'alternative indexing' or 'factor-based indexing' or even 'advanced beta'.
In Belgium, for example, traditional benchmarks Bel 20 and Eurostoxx 50 are slowly but surely being replaced as underlying for structured products in favour of smart indices, such as the Dynamic Deep Value Equity, Ethical Europe Equity, Finvex Sustainable & Efficient 30 and the iStoxx Europe Demography 50, with many distributors citing better terms, performance and the story behind these indices as the reason why. "Smart-beta indices have a better performance risk ratio compared with the traditional benchmarks," or "these indices provide a clear investment idea from an investor's point of view," and "consistent superior results with respect to the traditional benchmarks support our choice for these style indices," are just some of the comments from distributors in the Belgian market over recent weeks.
We asked Benedict Peeters (pictured), chief executive of Finvex, the independent Belgian consultancy which specialises in the design of advanced investment strategies, why smart indices tend to perform better than benchmarks.
"The stocks these indices consist of are selected carefully, following a mathematical analysis based on a number of processes where we try to avoid being subjective," says Peeters.
"So, first and foremost, it's all about rigorously following certain processes," says Peeters. "Secondly, these indices are often build on the principle of stable investing. Stable investing is something which not only is mathematically intelligent, but also low risk, and is known as an equity risk premium factor that works well during certain cycles. It is a known smart-beta strategy. The component of arbitrating shares in a portfolio in combination with improved risk characteristics is a known skill for achieving better results." The cycle needs to be positive, which is the case at the moment, but of course, this can change one day, admits Peeters. "It's not that low risk stocks are performing better year after year, but in the long term, as the past has shown us, better results can be achieved."
Even if you have a lesser performance cycle, if an equity portfolio is put together in a smart, intelligent manner based on risk characteristics, it should be possible to keep the volatility relatively lower compared to a standard benchmark index, so return per unit of risk could well be better even in lower performance cycles, says Peeters. "We also work on the index improvement by changing the weighting methodology," he says. "The fact is that benchmarks, if we may use that word, let's call them market capitalisation weighted benchmarks - because that's what they are - have often large concentrated positions in certain stocks." Peeters gives the Bel 20 and Eurostoxx 50 as an example. "If I am not mistaken, the Inbev share takes up half of the Bel 20 today. In my view you can no longer call this an index, even though this is clearly known as a benchmark," he says. "Or the Eurostoxx 50, one of the best-known benchmarks, if you take the first 15 shares, then you have already got almost 60% of the weight, not really risk friendly when you talk about '50' in your index name."
This is something you don't see with the Finvex indices, according to Peeters. "We spread more 'evenly' the risk between the stocks in the index. I'm not saying that this always has an impact on the return but it certainly has an impact on the stability." The return of an index is more a matter of selection, says Peeters. "We frequently select based on risk criteria and try to keep emotion out of it." In doing so, Finvex manages to create portfolios which meet certain quality standards, especially since sustainable stocks are also selected, says Peeters. "It is starting to become clear now that there is a shift towards sustainability. That also has an indirect impact on the market I think."
One of Finvex flagship indices, the Finvex Sustainable & Efficient Europe 30, which has been live since July 2011, has consistently shown better results on performance and historical volatility compared to the Eurostoxx 50. "We always work with historic universes and make sure data is perfectly checked," says Peeters. The results are further tested by independent third parties, he says. "Our indices are usually calculated by Standard & Poor's who do this independently of us." That sometimes leads to minuscule differences, for example due to a different treatment of dividends, but that is so negligible, says Peeters. "That means the validation is done objectively. That is wat we want," he says. "This is also evident from the figures. Everything we have done so far has performed live at least as well, if not better, than during the back test period."
In some other indices, such as the Finvex Sector Efficient Europe 30, Finvex is adding additional alpha by overweighting certain sectors because that is where the potential additional value is, says Peeters. "We use models which indicate that sector selection works but of course that's no guarantee for the future."
SRP's Belgian database list 26 structured products from 11 different providers linked to a Finvex index, including offerings from AG Insurance, AXA, BPost Bank, Crelan, Delta Lloyd Bank, Deutsche Bank, Optima Bank, Puilaetco Dewaay, Securex, SG Private Banking and VDK Spaarbank.
Click here to read the quarterly performance report for Finvex indices.
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