Smart beta – the fu­ture of mul­ti­man­ager and fund of fund in­vest­ing? Fund man­agers are us­ing smart beta strate­gies to im­prove the risk-ad­justed re­turns of pas­sive in­vest­ment funds.

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the Na­tional Trea­sury wants re­tire­ment funds to con­sider of­fer­ing pas­sive op­tions as part of de­fault in­vest­ment port­fo­lios. In draft reg­u­la­tions to amend the Pen­sion Funds Act, Na­tional Trea­sury has called for con­sid­er­a­tion of pas­sive funds in de­fault in­vest­ment port­fo­lios as many peo­ple are au­to­mat­i­cally en­rolled into re­tire­ment funds as part of their em­ploy­ment ben­e­fits pack­age, but are of­ten in­vested in in­ap­pro­pri­ate port­fo­lios. They may also be pay­ing higher charges than nec­es­sary. By en­cour­ag­ing in­vest­ing in pas­sive funds, port­fo­lio man­agers are look­ing at the most ef­fec­tive ways to en­sure they im­prove risk-ad­justed re­turns. One such strat­egy fund man­agers are con­sid­er­ing is what is known as smart beta.

Smart beta, a term be­ing used more fre­quently in in­vest­ment cir­cles, can of­fer nu­mer­ous ben­e­fits to in­vestors. “Beta” refers to volatil­ity or sys­tem­atic risk aris­ing from ex­po­sure to the over­all mar­ket, which is quan­tifi­able and mea­sure­able. A mar­ket cap­i­tal­i­sa­tion in­dex prod­uct that of­fers ex­po­sure to the South African mar­ket as a whole would be re­ferred to as a beta prod­uct.

Smart beta is a way of tak­ing var­i­ous sys­tem­atic risks in the mar­ket and iso­lat­ing them in or­der to use them more ef­fec­tively in port­fo­lio con­struc­tion to re­duce risk or en­hance re­turns.

Says Len Jor­daan, head of ex­change-traded funds at Stan­lib, who is driv­ing the group’s smart beta prod­ucts: “For ex­am­ple, you can con­struct smart beta to give in­vestors ex­po­sure to high-div­i­dend­pay­ing stocks.”

Another op­tion is to cre­ate a smart-beta prod­uct that pro­vides ex­po­sure to low-volatil­ity shares.

Smart beta is es­sen­tially a low-cost al­ter­na­tive to com­mon ac­tive man­age­ment strate­gies, but im­por­tantly, it is most ef­fec­tive when used in con­junc­tion with ac­tive man­age­ment as a bal­anc­ing fac­tor for an over­all port­fo­lio, hence its use­ful­ness for port­fo­lio man­agers.

Money man­agers con­struct port­fo­lios by look­ing at the risk fac­tors that are preva­lent in their un­der­ly­ing man­agers’ port­fo­lios. They take over­weight and un­der­weight po­si­tions in the un­der­ly­ing man­agers based on their over­all view of the risk fac­tors in the mar­ket. Every in­vest­ment style, whether it is value, growth or mo­men­tum, has its time in the sun. There are pe­ri­ods when cer­tain styles out­per­form or un­der­per­form the mar­ket. So­phis­ti­cated in­vestors man­age a risk bucket, al­lo­cat­ing cap­i­tal where they see the op­por­tu­nity for the high­est re­turn at an ap­pro­pri­ate level of risk, rather than sim­ply chas­ing the high­est re­turns.

The ad­van­tages for money man­agers of us­ing smart beta within their port­fo­lios are nu­mer­ous.

Blend­ing of fac­tors

Smart beta in­dices cre­ate a very true and clin­i­cal rep­re­sen­ta­tion of a risk pre­mium, whether it is an in­dex of low-volatil­ity shares or high-div­i­dend-pay­ing shares. Rather than buy­ing a gen­eral mar­ket cap­i­tal­i­sa­tion in­dex, man­agers can choose an in­dex with a spe­cific risk fac­tor ex­po­sure to use within their port­fo­lio.

Stan­lib’s Quan­ti­ta­tive In­vest­ment Strate­gies team takes this to the next level by us­ing a multi-fac­tor process of com­bin­ing risk fac­tors to achieve the de­sired risk/re­turn pro­file needed by the man­ager.

Says Te­boho Tsotetsi, co-port­fo­lio man­ager and quants an­a­lyst, who also forms part of Stan­lib’s Quan­ti­ta­tive In­vest­ment Strate­gies team: “We could have a client that is look­ing for ex­po­sure to a mo­men­tum fac­tor. How­ever our re­search has shown that de­spite the good re­turns over the long term, mo­men­tum stocks are typ­i­cally very volatile and can ex­pe­ri­ence huge draw­downs. In this in­stance, we would ad­vise the client to com­bine mo­men­tum with some­thing like

Smart beta is es­sen­tially a low-cost al­ter­na­tive to com­mon ac­tive man­age­ment strate­gies, but im­por­tantly, it is most ef­fec­tive when used in con­junc­tion with ac­tive man­age­ment.

Len Jor­daan Head of ex­change-traded funds at Stan­lib

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