The rise of smart beta strategies

17 April 2014   Category: News, Asia, Global   By Xiaowei Kang*

An important phenomenon that has shaped the investment industry since the 1970s is the rise of passive investing and the separation of alpha and beta. For decades, investors have used market-cap-weighted index strategies to capture low-cost exposure to the market beta, and relied on active managers and hedge funds to generate alpha.

The "third choice": However, in recent years, the boundary between alpha and beta has become blurred. There has been a growing recognition that systematic risk factors account for the majority of long-term portfolio returns, and that a significant portion of the alpha delivered by active managers and hedge funds can be attributed to systematic risk factors. In such context, there have been increased investor interests in so-called "alternative beta" or "smart beta", which is emerging as the "third choice" between alpha and beta.

The use of smart beta strategies has been mainly driven by two types of investors. Some investors are concerned about the construction of cap-weighted indices, and view smart beta strategies as a solution to address the perceived inefficiencies of cap-weighted indices. However, according to two industry surveys by Northern Trust and SSgA, the more important driver comes from investors who are disappointed with the performance and costs of active managers. These investors aim to use lower-cost smart beta strategies to achieve superior risk adjusted performance than the market, without employing active managers.

In a recent survey of 300 institutional investors1, 42% of the investors say they have committed a portion of their portfolios to smart beta, while a further 24% say they intend to do so in the future. Regionally speaking, Europe has led the way in the adoption of smart beta, as there are a much higher percentage of European institutional investors making allocation than that of North America and Asia Pacific.

Demystifying smart beta strategies: There is now undoubtedly a proliferation of smart beta indices in almost all major asset classes including equities, fixed income, and commodities. In equities and commodities, smart beta strategies typically capture some of the well-known systematic risk premia, such as small cap, value, low volatility, momentum and quality in equities, as well as curve, value, and momentum in commodities. In fixed income, as traditional cap-weighted bond indices give the largest weights to the most indebted sovereign issuers and corporate issuers, there has been development of fundamental based indices that overweight sovereign issuers with better fiscal strength and corporate issuers with lower credit risk.

Most smart beta strategies aim to achieve enhanced return and/or reduced risk than the market beta. For instance, Exhibit 1 categorises the well-known smart beta equity strategies into risk driven and return driven strategies. Importantly, investors often use either risk driven or return driven strategies for certain investment outcomes. For instance, low volatility and minimum variance strategies can reduce portfolio volatility as they reduce systematic risk through holding low beta stocks; however, such portfolios may be relatively concentrated and have higher stock specific risks than the market. In comparison, strategies such as equal weight, equal risk contribution and maximum diversification can reduce stock specific risks and achieve better portfolio diversification.

The return driven strategies typically aim to enhance return by targeting specific factor premia such as value, momentum and quality. One example is the fundamental index that weights companies based on fundamental measures of company size (e.g., book value and sales) as opposed to market capitalisation. Such strategy essentially overweights low valuation companies thus represents a systematic value tilt.

One of the drivers behind the increased interests in smart beta is its impressive historical performance versus average active managers. For instance, Exhibit 2 shows that, risk driven and return driven smart beta strategies such as low volatility, equal weight, fundamental index and quality index have all significantly outperformed the S&P 500 (the market beta) over the last 17 years. In comparison, the average active managers in US large cap equities have lagged the market benchmark S&P 500.

Potential challenges and opportunities: The development of smart beta strategies represents an alternative option for investors, as it expands the toolkits investors can use in constructing portfolios. Especially in North America and Europe, investors can now access a range of investment styles and strategies through smart beta ETFs, funds, or segregated mandates, in a low cost and transparent manner.

However, there are also significant challenges. First, investing in smart beta strategies essentially involves active investment decisions and passive implementation, so it entails a different investment process from traditional active and passive investments. For institutional asset owners, it may also pose governance challenges.

Secondly, the recent proliferation of such strategies makes the strategy selection and due diligence process a complex and time-consuming exercise. When it comes to the evaluation of different smart beta strategies, the devil is often in the details, and investors need to understand the implications of different portfolio construction methodologies, and evaluate such strategies through the lens of risk factors. Investors should also place emphasis on implementation cost, simplicity and transparency. Last but not least, smart beta strategies may significantly underperform the market over certain periods, because such strategies typically capture some risk premia factors, which can be cyclical. To reduce the risk of such potential underperformance, investors may combine different smart beta strategies to diversify across lowly correlated risk premia factors.

Despite the challenges, as investors become increasingly aware of the potential benefits and risks of smart beta strategies, the adoption of smart beta may continue to gather pace over the coming years. In particular, a multi-factor and multi-asset-class approach to smart beta investing, where the risk premia across asset classes can be systematically harvested via low cost vehicles, is likely to gain momentum.

*Xiaowei Kang is director of index research and design at S&P Dow Jones Indices.

1 See report "Advanced beta comes of age" by State Street Global Advisors (SSgA).