By Toby Goodworth
With all the column inches recently dedicated to smart beta investing, you’d be forgiven for thinking it was a brand new asset management concept. In reality, such alternative indexation approaches have been around for a couple of decades, yet it is only in the last couple of years they have garnered a more visible interest from institutional investors. Indeed, a recent bfinance pension fund asset allocation survey confirmed these trends, indicating that 43% of investors were considering initiating or increasing their allocation to smart beta approaches.
Given that the majority of smart beta strategies are clearly defined and very transparent, it is somewhat ironic that the term smart beta is actually a very opaque definition. Even the term smart beta itself is poorly defined, with the likes of alternative indexation, engineered-, customised-, or advanced-beta also vying for popularity. In its broadest sense smart beta can be defined as the systematic application of a set of index rules constructed to weight a set of constituents in a way that is not solely based on market capitalisation. Such a broad definition has meant that numerous investment approaches and products are now being labelled as smart beta, with potential signs of a marketing bandwagon in the making.
Thankfully, the taxonomy of smart beta investing is much simpler, with categorisations falling into four distinct approaches: Fundamental; typically based on blends of non-price metrics and accounting data. Risk efficiency; typically seeking to optimise risk, or risk-adjusted returns, at the overall portfolio level rather than screening from a bottom-up basis. Explicit weighting; direct calculation of constituent weights, e.g. equal weighted. More complex approaches may consider blending explicit weighting with traditional market-capitalisation weighted approaches at, say, sector or industry level, and finally Systematic risk factors; explicitly targeting predetermined risk premia using quantitative techniques to isolate stocks with the desired characteristics from the broader universe, e.g. momentum, quality or low volatility. More recently, advances from smart beta providers have seen their offerings straddle these definitions, for example fundamental and risk efficiency combined into a single approach. Arguably, even risk parity approaches could be considered a blended approach of explicit weighting and systematic risk factor methods.
The reasons underlying the growth in popularity of smart beta are multi-faceted. On one hand there is the consideration of cost. In the face of lower expected returns, investors have increasingly focused on reducing expense ratios. Here, appropriately chosen smart beta exposures are well positioned to provide a meaningful component of the returns previously generated by active management at a fraction of the cost. On the other hand, there are more strategic considerations; many investors see the development of smart beta as a natural evolution of alpha-beta separation at a more granular level, with alpha and beta having become alpha, intentionally selected risk premia, and traditional beta. In parallel with this argument, the predictability of returns associated with exposure to certain specifically chosen risk premia over active management has also been cited as an influential factor. Although that said, such view points are likely to have been heavily influenced recently by an environment which has hampered more fundamental bottom-up stock picking. As well as these pull factors aimed at active fund management, smart beta approaches have also been chipping away at investors’ traditional passive market-capitalisation weighted allocations. Here numerous recent academic and practitioner articles have highlighted not only the inefficiencies associated with market-capitalisation weighted indices, but also the improved risk-return characteristics available from many smart beta approaches.
Toby Goodworth is head of research at bfinance
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