Written By: Matthew Craig
Investors generally have faced a simple choice when appointing a fund manager. One option is to seek a skilled manager who aims to beat the market, while the other is to use an index-tracker that simply provides the market return.
Now, a third option, smart beta, is increasingly being used by investors. It accepts that beating the market is difficult and can be expensive. But rather than passively accepting the ups and downs of a conventional index tracking approach, smart beta aims to enhance the performance of a normal market index. For example, index trackers normally follow indices based on market capitalisation, such as the FTSE 100 or the S&P 500 benchmarks. A smart beta approach to these markets would aim to harness some of the forces that drive the market in a systematic and efficient way. Paul Bouchey, an investment manager at fund manager Parametric, said that smart beta approaches can appear to be radical at first glance. He sums up the essence of smart beta as: “I can’t pick stocks and I can’t time markets but can outperform the market consistently with lower risk.” Bouchey went on to say that smart beta differs from passive investing by taking a more active approach to portfolio construction. “It is not a set and forget approach. Effectively, you are trying to sell high and buy low.”
The approach Parametric starts with is to equal weight stocks. “For example, if you have 20 constituent stocks in a portfolio, all are at 5%. If you have a 20% rebalancing threshold, then when an asset goes up 1%, you take that 1% growth and rebalance from 6% to 5% and look for the most under-weighted assets and reallocate to that, to go back to equal weight”, Bouchey said. He added that this does two things. One is that is it provides diversification, the second is that it rebalances the portfolio regularly. Bouchey commented: “We don’t think we can time markets and we have given up on the idea that we can predict the future. All that is left is to diversify and control risk. Rebalancing forces us to sell against the market, so as a bubble builds up, we sell against the market.”
Some asset managers have practised this kind of investment strategy for some time, calling it systematic alpha, or alternative beta, but lately the term smart beta has been adopted, as it signifies the harnessing of market returns in an intelligent fashion. Bouchey added: “You might say that smart beta is a rebranding of quantitative investing as quant is now a bad word.” There are a number of different approaches within the overall smart beta category, but they all share a more systematic, rules-based approach that traditional active managers, while being less transparent than plain vanilla index-trackers.
Bedfordshire Pension Fund head of pensions and treasury management, Geoff Reader, commented: “Smart beta is one of those badges that covers a lot of different investment approaches. They have gained traction as a useful investment approach as there are some issues with market cap-weighted indexes which can be offset by smart beta. As usual, when the investment industry sees an opening it cannot stop itself flooding the market and creating the perception of the latest marketing fad.”
Reader added that the Bedfordshire Pension Fund uses a smart beta index for part of its passive investments. “It was introduced as a counter-weight to the market cap weightings it still holds. The smart beta used is the FTSE RAFI AW 3000 Equity Index and represents about 8% of the fund. Like other investors, local authority pension funds are getting more interested in how smart beta could add some extra performance returns to pure passive allocations, or replace struggling conventional active managers. Merseyside Pension Fund head of pension fund, Peter Wallach, commented: “With smart beta, I very much buy into the theoretical underpinnings of it. It is clear that there are persistent anomalies relative to the market cap-weighted benchmark that can be exploited.”
Wallach added: “We have had a minimum variance portfolio for five years and have had a good experience with that. The main part of the portfolio is in European equities with a smaller part in emerging market equities. I can see us doing more of it in the future, but there is a limit to what we can undertake at any one time.” West Midlands Pension Fund chief executive officer, Geik Drever, said: “We think that smart beta is a potentially useful investment approach. There is an ever-growing number of products in the market, and in assessing them, investors need to be clear what they specifically require.”
Minimum variance or low volatility portfolios are one variation of smart beta, which take advantage of the fact that low volatility stocks tend to outperform. This finding goes against the principles of modern portfolio theory, which teaches that higher risk and higher reward go hand in hand. Nevertheless, smart beta strategies aim to outperform market indices by making use of the low volatility anomaly, which has persisted for decades according to academics and reseachers. Wallach commented: “With a minimum variance portfolio, it isn’t simply low volatility stocks that outperform, but a low volatility portfolio. The minimum variance portfolio is not solely composed of low volatility stocks; some stocks which do not look like low volatility stocks are in it because they are lowly correlated.”
Among the reasons put forward for the outperformance of low volatility portfolios are the fact that high growth stocks tend to be bid up by investors and then over-correct. Once these stocks suffer a fall in value, their performance suffers due to negative compounding, which means a stock has to recover its value by 100% to make up for a 50% initial fall in value; or a share at £100 which falls to £50 in value, has to double, or increase by 100% to make up the fall. In real life scenarios, a smart beta strategy might underperform the market when performance is concentrated on a relatively narrow number of stocks, or one or two sectors, such as in the dotcom boom, but it would then beat the index when the bubble bursts.
Smart beta exponents also look for persistent risk factors which they can exploit in order to improve on the performance of market cap-weighted indices. Bouchey commented: “What is important to pension funds is the long-term compound growth rate – when you compound the returns you get a nice steady growth rate. If you reduce downside risks and do not shoot for returns, with a focus on risk management, you let returns take care of themselves.”
If smart beta makes sense in equity markets, it could be even more sensible in fixed income markets. This is because bond indices are known as “reprobates’ indices” in that the most heavily indebted stocks or countries are the largest components of the index. These stocks with large debts are arguably risky for investors. Commenting on the prospects for bond investing in 2014, Mark Benstead, global head of smart beta credit at AXA Investment Managers, said: “Capital appreciation in credit is looking unlikely this year given the expectation that yields are unlikely to move much. This leaves interest income – or carry – as the main source of return from credit. With this in mind, low portfolio turnover is anticipated as investors maintain their positions and harvest coupon payments. Buy-and-monitor investment strategies have the upper hand as they are designed to have low turnover, capture the carry trade and harvest the beta (return over the risk free rate).”
Given the growing interest in smart beta, it is not surprising that there is increasing activity in creating products and strategies for investors. For example, asset manager Amundi has just announced a strategic partnership with index provider, ERI Scientific Beta. Amundi global head of ETF and indexing, Valérie Baudson, said: “By partnering with ERI Scientific Beta we will be able to offer our clients efficient indexed managed solutions including the very latest in smart beta index construction expertise.”
In conclusion, smart beta strategies should not necessarily be seen as an investment fad, although the term “smart beta” is perhaps a piece of smart marketing. Enhanced indexing, quant investing and exploiting risk factors have all been investment tactics in use for some time and arguably smart beta is an umbrella term for approaches like this. By using a disciplined rebalancing system, combined with the use of market anomalies, smart beta strategies aim to smooth out the returns of market cap indices and, over the long term, produce better returns for investors. But the all important caveat remains for investors; they need to thoroughly research potential providers and ensure smart beta managers are equipped to do what they say they can and that there is evidence they have successfully done so in the past.