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‘Disruptive innovation’, a term coined by Harvard Professor Clayton Christensen, describes a process by which a product initially takes root in simple applications at the bottom of a market and then relentlessly moves up market, eventually displacing established competitors.(1)
For many investors the difference between passive and active investment approaches is clear cut. A ‘passive’ solution is one that is low-cost and requires a simple investment in a market capitalisation index. Any strategy crafted differently to this approach is considered ‘active’.
Fast forward to 2017 and we are witnessing a challenge to this convention.
‘Smart Beta’, a hybrid of active and passive, has gained significant interest in the industry as it is a way of delivering investment strategies in a low-cost, transparent way.
Smart Beta is similar to passive because it is rules-based and low-cost and has similarities to active because it varies from market capitalisation.
In reality a large percentage of active strategies can be explained within a defined set of rules. Essentially Smart Beta has the potential to offer investors an active portfolio strategy at a fraction of the cost without investors having to sacrifice on return, risk or objectives.
Smart Beta Application: A South African case study
An investment strategy in which active managers seek to buy equities with attractive dividend metrics is a trusted strategy and one that has recently gained traction in the global search for yield. These dividend strategies tend to rely heavily on rules and quantitative processes and therefore can be replaced with an equivalent Smart Beta approach. The following study sets out to examine dividend strategies within the SA market, and to establish whether or not Smart Beta can start displacing existing active funds.
CoreShares collected data on all retail equity funds in the SA market that have a dividend specific focus as part of their mandate. There were a total of five (5) funds with a combined assets under management (AUM) in excess of R10 billion.
Once selecting the funds with a dividend specific focus we documented each of the funds key characteristics that were sought when selecting shares. Figure 1 below, shows each of the funds objectives.
Figure 1: Dividend equity funds in South Africa and their investment rules
Following this we then refined these selection criteria into the below three (3) general characteristics:
In the figure below we have shown five funds based on their general characteristics and have ordered their selection priority from left (highest priority) to the right (lowest priority).
Figure 2: Dividend equity funds in South Africa and their investment styles distilled
When assesing Figures 1 and 2 above, it is not clear which of the five funds are active and which are Smart Beta. What this exhibits is Smart Beta’s ability to replicate investment strategies succinctly in a rules based environment. However for the client what is of greater importance is the relative success of the funds in achieving their intended objectives For the purpose of this case study we consider generating dividend income as the primary objective.
Table 1 shows the net cash flow that would have been paid to an investor if they had invested R1 million in each fund on 01 May 2015 and withdrew all distributions until 30 April 2017.
Source: Morningstar, as at 30 April 2017
Table 1: Quantitative comparison of funds in South Africa, 3 Years ended 30 April 2017
In Table 1 above, Funds A, B and D are active funds and C and E are Smart Beta funds. Fund E is the CoreShares Dividend Aristocrats ETF (Share Code: DIVTRX) Using a simple average the income generated per portfolio was 49% higher for Smart Beta and using an AUM weighted measurement the income generated was 87% higher for Smart Beta.
It is important to be aware of the reasons behind the difference in outcomes and whether or not a fund has a structural advantage over another. One of the main explanation is cost. A significant component of Smart Beta’s advantage when delivering on income generation for clients is the low-cost and efficiency with which it is able to replicate investment strategies.
In the instance of dividend strategies the cost efficiency is amplified. Investment fees which are subtracted from income accrued means a high fee structure will significantly detract from a funds ability to deliver on its primary objective of delivering high dividend income. Figure 3 and 4 below, illustrates this point and shows the negative relationship between income generated for clients and fees. This negative relationship is a similar finding to the recent Morningstar research (2) (K.Cox, 2017) wherein it is established that the least costly funds had the highest chance of future total return success.
Source: Morningstar, as at April 2017
Figure 3: High fees result in lower income generation for clients
Source: Morningstar, as at April 2017
Figure 4: High fees erode high gross yields resulting in lower client cash flow
Because of high costs the majority of active managers, even those with higher gross yields, struggle to deliver a favourable relative net yield thereby detracting from their primary value proposition.
It is clear from these findings, that dividend equity strategies using Smart Beta have great potential in the SA market by offering clients more value for fees paid.
“What is new about Smart Beta is not the (investment) idea – but the simple and transparent packaging. Carving out and lowering the cost of one significant component of active management.” Khan & Lemmon 2016
CoreShares believes that Smart Beta building blocks will start to play a much more meaningful role in the SA asset management landscape.