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Can robots beat fund managers in hunt for income?
Formulas and algorithms lie at the heart of the launch of a new series of income-generating exchange-traded funds from Source ETF.
by Daniel Grote on Mar 11, 2016 at 14:37
It's been a good week for artificial intelligence. Google's AlphaGo programme yesterday took a 2-0 lead in its series of 'Go' matches with Lee Se-dol, world champion of the complex board game originating from China.
Formulas and algorithms also lie at the heart of the launch of a new series of exchange-traded funds, which rely on quantitative methods, rather than the analysis and investment philosophy of a fund manager, to deliver income.
Source ETF has launched three new funds, focused on delivering income from the UK, US and European stock markets.
And while the ETF provider is not laying claim to any artificial intelligence, the launches are an example of 'smart beta' investment approaches that are proving increasing popular.
Smart beta is a type of passive investment, which tracks markets rather than relying on a manager to beat it. But while mainstream passive investments track recognisable indices like the FTSE 100 or the S&P 500, smart beta approaches track indices constructed to target a particular investment outcome, such as an income higher than that of the broader market.
Some are more complex than others in their approach. One of the largest, and oldest, UK income-focused passive fund, the £798 million iShares UK Dividend Ucits ETF (IUKD ) has a relatively straightforward approach. It follows the FTSE UK Dividend+ index, which is composed of the 50 highest yielding stocks on the FTSE 350 based on their one-year dividend yield forecasts, weighted according to that yield rather than market capitalisation.
Another popular UK income passive fund, the £804 million Vanguard FTSE UK Equity Income , takes a slightly different approach. It tracks the FTSE UK Equity Income index, which ranks stocks by their forecast yield, including the highest yielders and weighting them by their market cap. There are further rules that prevent too much being held in a particular stock or sector.
The Vanguard fund, launched four years after the iShares ETF in 2009, represented a move away from the more basic yield-weighted approaches that had been the norm for income-focused passive funds.
Source ETF, with its new income-focused funds, is using a different and more complex approach. The three ETFs it is launching are based on indices developed by Research Associates.
These indices first screen the stock market they are focused on using a 'robustness rank' based on the ratios of income to book value and cash flow to debt and the difference between assets and liabilities.
The 20% weakest stocks under this measure are then excluded. Then, within each sector of the market, such as healthcare, basic resources and media, only half of the stocks are admitted, those with the highest dividend yield.
Sectors are weighted depending on what Research Associates calls their 'fundamental weight', based on the sales, cash flow, book value and dividends of the companies it has selected for each. Stocks within those sectors are then weighted according to this fundamental weight, multiplied by their yield.
It's a complex method, but Source and Research Associates said they wanted to avoid an approach that was based solely on yield, or market capitalisation weighting.
'If you just simply go for the very high yield, you tend to get low quality companies,' said Charles Aram of Research Associates. 'You're into moribund industries throwing off their cash.'
A market cap weighting also has its problems, he added. 'A market cap weighting has the unfortunate impact of participating in bubbles and fully in the subsequent declines,' he said.
Adam Laird, passive investment manager at online stock broker Hargreaves Lansdown, said he was reserving judgment on the approach.
'The Research Associates methodology is a lot more complex and very much about looking at company fundamentals and using that to weight them,' he said. 'It's probably too early yet to judge them because the products are new. We need to see how it works.'
One major difference between the new ETFs and the Vanguard and iShares funds is that Source will rely on actual dividends paid, rather than forecasts of future payments, in determining their index.
That means that previously high yielding companies that have already declared they are scrapping their dividends will remain in the index until the date at which they would have been due to pay arrives. And even then, the stock won't get kicked out until the index's annual rebalancing.
A look at the Source FTSE RAFI UK Equity Income Physical ETF's (DVUK) holdings bears this out. Standard Chartered (STAN) sits just outside the top 10 with a 4% weighting, despite having already declared a final dividend for 2015 will not arrive in May.
Anglo American (AAL), which has said it won't pay a final 2015 dividend next month, and has suspended future payouts until the end of 2016, also features as a 2.2% holding. That may see the ETF's yield, currently 4.8% ahead of the FTSE 100's 4.2%, diminished.
'With all Research Associates strategies, they are not perfect and not seeking perfection,' said Aram. They are seeking to give investors a portfolio that is sturdy and robust over time and deliver in a reliable fashion. It's not a magic bullet; it's been designed with certain features in mind to keep it on the road.'
Laird added that although a focus on historic yield had its drawbacks, the alternative, of using dividend forecasts, also presented problems when analyst projections were proved wrong.
What is clear, however, is that passive investment, and smart beta strategies, are on the rise. In the last year, assets held in index tracker funds and ETFs on Hargreaves Lansdown's platform jumped 28%, and smart strategies are proving increasingly popular. 'Its making its way into more and more individual portfolios,' said Laird.
Fundamental to the popularity of these investment approaches is their cost. With an ongoing charge of 0.35% a year, the Source ETFs, which also include the Source FTSE RAFI US Equity Income Physical ETF (DVUS) and Source FTSE RAFI Europe Equity Income Physical ETF (DVEU.DE), are cheaper than the iShares' 0.4% levy, although Vanguard undercuts all of them with a 0.22% fee. But with charges of most UK equity income active managers sitting around the 0.75% mark, cost has been a key driver in spurring investors into considering the passive approach.
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