What are smart beta investment strategies?

Learn why smart beta strategies are increasing in popularity

Whilst there is no industry-accepted definition of what smart beta is, it is essentially used to describe passive or rules-based investment strategies which have been constructed in a “smarter” way than traditional indices which allocate to securities based on market value. The smart beta rules are designed to try to provide higher returns and/or lower risk relative to passive investment strategies based on traditional market indices such as the S&P/ASX 200 index in Australia.

In the past, investors had two choices: either active portfolio management through an actively-managed portfolio where an investor or fund manager picks securities, or passive investment by replicating traditional market indices. There are problems with both approaches; active managers (as a whole) are generally unable to consistently outperform market indices after fees and they are relatively tax inefficient given the higher portfolio turnover. On the other hand traditional passive investment strategies allocate the largest parts of the portfolios to securities that are possibly the least attractive because their price has risen strongly in the past and therefore they have a large market value. For example, Apple’s weighting in the S&P 500 index in the United States has tripled in the past five years, to around 4.2%, and Commonwealth Bank of Australia now accounts for nearly 7% of Australia’s S&P/ASX 200 index. In bond markets, market based indices are also heavily weighted to those entities that have borrowed the most, e.g. the US Government which is not always the best place to invest, particularly when monetary policies have artificially held bond yields very low.

Smart beta strategies attempt to create indices that are not based on the size of the company or amount of debt borrowed, but can be based on other rules, that over time, have been shown to provide better returns to traditional indices and often with lower risk. Examples of smart beta indices are equal-weighted indices, fundamental indices (where weighting can be based on the revenues or assets of the company), volatility or risk-weighted indices or indices that are weighted more heavily towards stocks with the highest dividend yields or lowest price-to-earnings ratios. In fact, there are a very large number of potential smart beta indices and strategies that have been created.

The benefits of smart beta strategies is that they share some of the same attractive attributes of traditional market capitalisation-weighted indices, such as diversification, broad exposure to the market, liquidity, transparency and the smart beta funds are lower cost than actively-managed funds. They also offer the potential for higher returns than market value-weighted strategies because smart beta strategies are more heavily weighted to smaller companies, companies which display better valuation metrics or which have lower volatility and more stable earnings.

According to the MJ Hudson Allenbridge Systematic Factor Market Review, in 2017 the amount of money invested in smart beta products was around US$1 trillion after having doubled in the prior three years. However, as with every investment strategy, smart beta strategies aren’t without their problems and risks. For example, just because a strategy outperformed traditional indices in the past doesn’t mean that it will outperform in the future. Also smart beta strategies may have lower liquidity (given the higher weighting to smaller companies) and higher transaction and management costs relative to a simple market capitalisation-based approach. They also tend to change the securities in a smart beta index more frequently than traditional indices, leading to higher portfolio turnover and lower tax efficiency.

 

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