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August 2016
Max Cappetta, CEO, Redpoint Investment Management

The evolution and growth of interest in ‘smart beta’ strategies is a dominant trend in financial markets. An explosion of interest in these strategies has resulted in a chaotic environment causing confusion about what so-called ‘smart beta’ strategies actually are and why and how investors should consider them.

What are smart beta strategies?

Making sense of the term ‘smart beta’ or ‘systematic beta’ requires an appreciation for the evolution of our understanding of drivers of market return and risk.

The 1980s heralded major growth in passive or index strategies. This opened a divide between beta strategies – passive, market cap weighted portfolios – and alpha strategies – portfolios delivering returns in excess of beta. Alpha was the exclusive domain of active managers and debate was focused on cost-effective capture of the alpha component – moving from all active to indexing the core of a portfolio and adding active satellites.

More recently style and factor analysis has shown that there are systematic elements in the world of alpha – some of the components of alpha are simply rewards for taking systematic exposure to known drivers of stock returns. Concepts such as a value premium (holding cheap stocks) or small cap premium (holding smaller companies) or low volatility premium (holding less volatile, more stable companies) are some examples.

Smart beta or systematic beta strategies look to capture these return drivers – delivering some of the alpha at lower cost – and now add another dimension to the debate. They adopt a set of rules for weighting stocks in a portfolio to systematically tilt the portfolio to selected drivers. The rules for weighting are generally fixed, for example, equal weighting or cap weighting a selected subset of the universe. And they are applied periodically, with portfolio rebalancing implemented at specific intervals – typically quarterly or annually.

Why are they becoming so popular?

Lower cost – coupled with simplicity – is often cited as a reason for the growing popularity of systematic beta strategies. And simple solutions to complex problems have a natural appeal.

However, there may be a misconception that these systematic strategies encompass all (if not most) of the alpha, or value add, available to investors. And given the complex nature of financial markets, investors should be wary of loading up on strategies with apparently strong past performance – while the factors often have a long-acknowledged history, most of the strategies offering to capture them have limited live histories.

Should I consider using them?

When it comes to assessing any systematic beta strategy, investors should ask three key questions:

  • Does the strategy have true investment insight? Look for an economic rationale for why the strategy should add value.
    If there isn’t one, view past success with scepticism.

  • Is the strategy a ‘proxy’ for something else? Ask whether there is something ‘special’ about a portfolio that equally weights the largest 300 companies, or is it just a crude way to increase exposure to smaller companies.

  • Does the portfolio construction manage the return, risk and cost trade-off? Consider an example – screening out companies with poor sustainability (ESG) metrics. A simple in-or-out rule can result in a very unbalanced portfolio. Was outperformance delivered because the strategy selected inherently better companies, or was it lucky with a semi-permanent bet that screened out most of a sector with poor recent performance (think resource stocks in Australia).

How can I use them in my portfolio?

Systematic beta strategies can provide a low-cost alternative to active management where suitable managers cannot be found or are excessively expensive. Their use by institutional investors is growing as they can provide alternatives where active management is unavailable due to capacity constraints or as flexible and complementary exposures to other active managers in multi-asset portfolios.

Systematic beta strategies can also provide specific outcomes desired by investors. Strategies that deliver consistently lower volatility or higher income, for example, may be better aligned with particular investors’ objectives. These strategies may or may not outperform the traditional passive benchmark but other characteristics of the outcome may be more important to those investors.

What innovation is there still to come?

Some strategies are still evolving in terms of sophistication: decision rules, portfolio construction and rebalancing will all become more nuanced. Some will combine multiple strategies and possibly morph into quantitative active strategies. Some firms will be more successful than others at keeping up and leading this evolution. What should remain is a core set of insightful systematic beta strategies that can be key building blocks for portfolios.

Is this the end of traditional active management?

Active managers now have a higher hurdle to prove themselves. While the alpha element of portfolio return has some systematic components, there remains scope for good managers to better this. This ‘proprietary alpha’ is the product of investment research and analysis. Collection and analysis of public information, processed in conjunction with a manager’s own evolving insights, creates proprietary information. Managers that consistently meet this hurdle will continue to provide valuable outcomes for investors.

It’s tempting to think that we can all beat the standard, passive benchmark return – that we can out-smart beta. But the reality is, not everyone can. Investors should ensure that they are well-informed and ask the right questions regarding systematic beta strategies. Finding and using the right strategies can deliver improved outcomes for investors. 

Read more articles from the latest Benchmark magazine.

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