Vanilla, smart beta, factor investing… let’s unpack what it all means.
Index-tracking has evolved over time. Let’s start at the very beginning with vanilla indices. A googled definition of vanilla would suggest words like standard, basic, ordinary. Computer software is described as vanilla when it has not been customised in any way. So too vanilla in index terms refers to a traditional market-cap weighted approach – well-known examples are the S&P 500 (US market), the FTSE 100 (UK market) and our own FTSE/JSE Top 40 index. The index constituents are simply weighted by their size or market cap (shares-in-issue multiplied by price). Vanilla index tracking funds have an important role as they are usually very good proxies for getting broad market exposure.
But what if you could apply more than just company size in constructing your index? What if you wanted to access very specific factor exposure? Or a portfolio consisting of only high yielding stocks? Enter smart beta.
Smart beta refers to any index strategy that moves away from company size or price (market capitalisation) as the main determinants for the weighting of a share in an index. Smart beta attempts to capture those common risk characteristics (factors) such as value, quality or momentum that seek to provide investors with a compensating return (premium) over the market for exposure to that risk. Smart beta index funds attempt to capture excess returns in a systematic way.
Let’s review three Satrix smart beta funds
The first smart beta fund in the Satrix suite was the Satrix Divi + ETF, which listed on the JSE in 2007. It tracks the FTSE/JSE Dividend Plus index which is designed to maximise dividend yield by investing in 30 companies that are expected to pay the best normal dividends over the forthcoming year. Note how the selection of shares is not based on the market capitalization of the shares, but rather the ability of the company to pay superior dividends.
The Satrix Momentum Index fund tracks a proprietary Satrix index, designed to include shares that exhibit strong momentum characteristics. Momentum investing in simple terms reviews the trend in a stock’s price and/or earnings, coupled with the principle that a stock that has been going up will continue to go up, while a stock that has been going down (negative momentum) will continue along the same downward path. A momentum index is constructed to include stocks with positive momentum and avoid those with negative momentum.
The Satrix Quality index fund tracks the S&P Quality South Africa index which is designed to include high quality stocks that are selected using a quality score. This quality score is calculated based on a company's return on equity, accruals ratio and financial leverage ratio.
How factors perform over time
The factors mentioned above (value, momentum, quality) have been found to be significant in the South African market. It is also important to note that factors perform in cycles, and that past performance is no indicator of how the factor will perform in future. To illustrate this, the performance numbers show that 2016 was certainly the year of the “value” factor, but it had dismal returns in the four preceding years. The momentum factor on the other hand had a negative return in 2016, following a sterling performance run every year since 2010!
If the stock market is driven by a particular risk factor over a given period, one should expect that funds targeting that factor should also do well and vice versa.
A REVIEW OF SOME INDEX PERFORMANCE NUMBERS
The table below shows how various indices we track have performed over the periods specified. You can also see whether we track it via an ETF or Unit Trust.
Index performance to 31 March 2017
POSTED : 3 MAY 2017