Smart beta is an alternative to the traditional active and passive investment strategies, but watch out for the pitfalls, warns Andrew Holt.
Smart beta is everywhere. It has become ubiquitous in the financial press, developing into one of the most discussed investment strategies of recent times. Debate has continuously surrounded its approach. None other than The Financial Times has noted it is a rather elusive concept.
Its elusive nature can be attributed to the many ways smart beta can be described: systematic beta, alternative indexation, factor investing and alternative beta.
Smart beta can though, simply be defined as a combination of active and passive investing. It is active in that it aims to outperform an index after taking risk, return and cost into account.
It is passive in that implementation is in the form of an exchange-traded fund (ETF) or index fund but captures themes that have traditionally been part of active strategies, but usually at a much lower fee.
And the reason the outperformance is called smart beta rather than alpha – alpha is associated with a manager’s skill. Since these are passive, no manager skill is involved.
The idea to capture such active themes, consistently and inexpensively, in a passive oriented portfolio, is a powerful and appealing idea. “It is a smart way of thinking about investing beyond traditional active and passive,” says Sara Shores, Black- Rock’s global head of smart beta.
Smart beta advocates note that it seeks to enhance returns, improve diversi cation and reduce risk–factors institutional investors adore, and frequently require.
It is, therefore, not a surprise that this is a growing segment for investors. Adoption of smart beta has spread to more than half of asset owners globally, according to a one survey.
Is this growth in assets likely to continue? Clive Gilchrist, trustee executive at BESTrustees, identifies a difference between defined benefit (DB) and defined contribution (DC) pension schemes towards smart beta, with the latter favouring a so- called ‘tilt’.
“The DB schemes I deal with are substantially de-risked with low or no equity content, to the point where such strategies are not considered,” he says. “In the DC space, various types of climate tilt or ESG tilt are frequently used – and that use is growing.”
What then is likely to drive further growth in smart beta: the returns, the diversification or lower fees? “It seems mainly to be driven by perceived risk reduction,” Gilchrist says.
Given its sharp impact, smart beta is also viewed as something of a disruptor to active management. “It has been considered as a cheap alternative to traditional active management,” Gilchrist says.
This disruption has included an unprecedented shift from active to passive management due to, it has to be said, the continued underperformance of active managers, as well as a low expected return environment. For some, smart beta works best when used for a specific reason, such as to deliver diversification or uncorrelated returns, rather than as a core holding in a portfolio.
And here there is a need for investors to truly understand that the outperformance of some of the factors that smart beta are based on can require prolonged periods of time to become evident. A point made by Elizabeth Fernando, head of long-term investment strategy at workplace pension scheme Nest.
“With smart beta investing, it’s important to commit over the long term, as risks are not rewarded consistently over time,” she adds. “At some points they can be extremely well compensated and others less so, and you will lag behind the market cap weighted market.”
Fernando also observes: “As with all strategies, the price you buy at does matter. When many investors prioritise the same factors it can cause overcrowding and future returns can be lower.” And she warns: “There’s a need to be wary of the ‘latest hot new trend’.”
An example, says Fernando, could be a green bubble in public equities as investors look to increase exposure to ‘green’ companies. “It’s something we are carefully monitoring and making sure we are clear on the financial case behind our level of exposure,” she adds.
But smart beta does not always work in practice. “Smart beta funds do not offer a risk-adjusted performance superior to active and passive strategies,” noted Youssef Louraoui from École Supérieure des Sciences Economiques et Commerciales Business School, in the paper, Is smart beta smart?
The failure was especially seen during the turbulent markets we saw as the Covid pandemic took hold. According to Morningstar, more than half of smart-beta funds underperformed their benchmark last year. The analysis found that such funds were hurt by their propensity to be dominated by small and mid-cap stocks, which has meant they have not been as resilient as the overall market during the pandemic.
There has also been a slowing in the number of smart beta products: 13 ETFs tagged by Morningstar as smart beta had launched in the US in the opening nine months of the year. That compares with 21 in 2020 and 65 in 2017. Although it could be a market beginning to mature because, looking at US smart beta ETFs in isolation, nearly three quarters of them were launched since 2010.
When many investors prioritise the same factors, it can cause overcrowding and future returns can be lower.Elizabeth Fernando, Nest
Something else could be at play. Academic paper The Smart Beta Mirage found that smart beta ETFs suffered from a “sharp” drop in performance after they were launched. According to co-authors Yang Song at the University of Washington and Shyang Huang and Hong Xiang at the University of Hong Kong, the average return of smart beta indices drops from 2.77% per year before ETF listing to -0.44% per year after listing.
They stated in the paper: “We find evidence of data mining in constructing smart beta indexes as the post-ETF-listing performance decline is much sharper for indexes that are more susceptible to data mining in back-tests. Our results caution the risk of data mining in the proliferation of ETF offerings as investors respond strongly to the stellar performance in back-tests.”
None of which has stifled the popularity of smart beta. Products classed as smart beta attracted about $44bn (£32bn) in net flows during the first nine months of 2021, according to one asset manager.
Equity-based Smart Beta ETFs and ETPs listed globally gathered net in ows of $27.92bn (£20.31bn) in the first quarter of 2021, bringing year-to-date net in ows to a record $57.4bn (£41.76bn), which is higher than the $8.97bn (£6.53bn) gathered at the same point last year.
Year-on-year through the end of the first quarter of 2021, Smart Beta Equity ETF/ETP assets increased by 12.5% from $1trn (£728.6bn) to $1.12trn (£816bn), with a five-year compound annual growth rate of 22.8%, according to consultancy ETFGI, making this a record year for Factor ETFs. The UCITS Factor ETF category has grown by 25% each year for the past five years and while ETF growth headlines have been taken over by sustainable and thematic ETFs – the ‘factor’ category has been growing steadily.
“Portfolio managers continue to use factors to position their portfolios to changes in the economic cycle, whether positioning for economic growth or building resilience, Factor ETFs are effective tools to help achieve desired portfolio objectives,” says Anthony Kruger, EMEA head of Factor ETFs for iShares.
The creation of effective Covid vaccines created a huge demand for value focused ETFs as investors sought out companies that were exposed to accelerating economic growth coming out of global lockdowns. “We have also recently seen investors using quality ETFs to build portfolio resilience as markets have become more turbulent and inflation worries are grabbing headlines,” Kruger says.
Single Factor ETFs continue to be the leading category, either for tactical or strategic asset allocation complimenting existing positions or providing diversification at the core of the portfolio. Institutional investors seem to be turning to Factor ETFs in favour of active products for cost and/or performance reasons.
“We see these applications of Factor ETFs as the main driver of future growth, as investors seek these broad, persistent drivers of return available in transparent, low cost, liquid vehicles,” Kruger says. “All investment decisions are active, and Factor ETFs are tools that can complement and enhance these decisions.”
Nest revealed it is expanding its activities in private markets, such as green infrastructure, where the required investment for the transition to the low carbon economy is potentially limitless. And here Nest incorporates factor driven tilting when investing in its public equity funds to manage the portfolio’s exposure to carbon emissions, something that has proved to be highly successful.
“The climate tilt allows us to increase investment towards companies successfully managing the transition to a low-carbon economy and underweights or even excludes companies that are failing to position themselves for the new economic realities,” Fernando says.
“This allows us to bene t from a passive approach to keep costs down while simultaneously, over the longer term, reducing the climate risk facing our members as global economies transition away from fossil fuels,” Fernando adds. “We believe this will help protect member returns.”
But, Fernando says, smart beta needs to be understood by investors, especially in terms of risk. “There’s still a role to play in using fund managers to actively navigate alternative asset classes, such as commodities and private credit, where expertise in the various markets and specific technology is important,” she adds. “All investors need to carefully consider the risks and rewards of passively entering a market to ensure it fits the level of risk they are willing to take.”
As even similarly named smart beta funds can yield uncontrollably different results, especially over shorter periods of time. “Investors need to do their homework,” says Ben Johnson, director of global exchange-traded fund research at Morningstar. “They need to sharpen their pencils and do every bit as much of due diligence when vetting these strategies, vetting their processes.”
It has been predicted that in the future, active portfolio management will be divided into two distinct categories: smart beta, with lower fees, and ‘pure alpha’ at higher costs, which would be set up by only a few managers with above-average research and financial engineering capabilities. With the view that an asset manager should not try to do both smart beta and pure alpha but focus on one of the two strategies.
Looking at smart beta, Youssef Louraoui notes in his paper that investor prudence is key: “The smart beta approach may enable investors to increase portfolio performance while managing factors such as portfolio outperformance, portfolio volatility relative to the market, or portfolio diversity.
“It is a tool that must be used prudently in order to be able to con rm at the end whether it is smart.”
SMART BETA IN SHORT
The smart beta approach is constructing a portfolio based on several yield enhancement ‘factors’:
- – Quality, which studies the financial environment of the underlying asset.
- – Volatility, which filter assets according to their risk.
- – Momentum, identifies trends in the selection of assets to be retained by focusing on stocks that have performed strongly in the short term.
- – Growth, the approach that aims to select securities that have strong return expectations in the medium to long term
- – Size, which aims to classify according to the size of the assets.
- – Value, which seeks to denote undervalued assets that are close to their fundamental values. This approach is opposed to the classic vision of portfolio construction based on market capitalisation weightings.
Source: Is smart beta smart? by Youssef Louraoui, ESSEC Business School