Is smart beta a smart bet?

Smart beta prod­ucts aim to marry the positive ben­e­fits of ac­tive man­age­ment with a cost that is closer to a pas­sive prod­uct but de­spite ris­ing pop­u­lar­ity they have their crit­ics

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‘Smart beta’ is gain­ing trac­tion as a method of in­dex in­vest­ing as in­vestors adopt a grow­ing range of strate­gies that have been used to gen­er­ate out­per­for­mance by ac­tive man­agers for years.

Some $6bn flowed into smart beta ex­change-traded funds (ETFs) in Europe last year, tak­ing to­tal as­sets un­der man­age­ment to $46bn, data from Black­Rock shows.

The as­set man­ager’s ETF sub­sidiary iShares points to three trends cat­a­pult­ing smart beta into the main­stream: lower re­turns for longer, cost con­scious­ness and ad­vances in port­fo­lio con­struc­tion.

‘We ex­pect ap­petite for smart beta strate­gies to con­tinue to in­crease as in­vestors seek im­proved in­vest­ment out­comes be­yond what traditional mar­ket cap weighted in­dices can of­fer,’ says An­thony Kruger of its spe­cial­ist sales team.

One such in­vestor is Jim Mackie, an in­vest­ment di­rec­tor in Brooks Mac­don­ald’s Lon­don­based multi-as­set team. It is ac­tively look­ing to add smart beta strate­gies to its pas­sive model port­fo­lios.

‘Firstly, the avail­able prod­ucts may en­able us to ex­press a par­tic­u­lar in­vest­ment view in a cost ef­fec­tive man­ner which may, in turn, dif­fer­en­ti­ate our port­fo­lios from more main­stream of­fer­ings,’ he says.

‘Se­condly, we be­lieve it makes sense where pos­si­ble to use funds that have a proven track record of out­per­form­ing their bench­mark in­dex in both up­ward and, more im­por­tantly, down­ward mar­kets.’


Also known as ‘al­ter­na­tive beta’ or ‘fac­tor in­vest­ing’, smart beta recog­nises that pas­sive in­vest­ing rel­a­tive to a mar­ket cap­i­tal­i­sa­tion weighted in­dex may not be the best ap­proach and that other met­rics should be used in­stead. Pop­u­lar funds in­clude those that equally weight stocks in an in­dex or fo­cus on fac­tors like low volatil­ity, high yield, value, growth, qual­ity, mo­men­tum and size.

London-based Cap­i­tal As­set Man­age­ment, a long-term pro­po­nent of pas­sive in­vest­ing, favours the Di­men­sional UK Value (GB0033771659) and Di­men­sional UK Small Com­pa­nies (GB0033772061) funds to tilt hold­ings towards value stocks (com­pa­nies that are cheap rel­a­tive to fun­da­men­tals) and small and mid cap stocks.

‘There is now a sig­nif­i­cant body of aca­demic re­search that sup­ports the view that fac­tors such as small cap, value and prof­itabil­ity are likely to de­liver above broad mar­ket re­turns over the longer term,’ says its chief ex­ec­u­tive Alan Smith.

‘This seems to make in­tu­itive sense on a risk/re­ward ba­sis in that smart beta in­vestors are ef­fec­tively tak­ing more risk than broad mar­ket in­vestors and would, there­fore, ex­pect a greater re­turn.’

Canac­cord Ge­nu­ity Wealth Man­age­ment used the UBS MSCI USA Value ETF (UC07) to get ex­po­sure to the un­der-owned and unloved US value space ear­lier this year.

While The­sis As­set Man­age­ment does not cur­rently have any ex­plicit core smart beta al­lo­ca­tions, it makes long-term al­lo­ca­tions to take ad­van­tage of his­tor­i­cally out­per­form­ing fac­tors like mo­men­tum. Sim­ply buying more of what has al­ready done well has pro­vided more than dou­ble the re­turn of the MSCI World in­dex over the last 30 years (2,473% ver­sus 945%), ac­cord­ing to port­fo­lio man­ager Adam Bur­niston.

Kruger at iShares be­lieves mo­men­tum will con­tinue to do well against the cur­rent back­drop of strong earn­ings mo­men­tum and a solid global growth outlook.

‘We’ve seen par­tic­u­larly strong flows into risk-on fac­tors like mo­men­tum and ex­pect this trend to con­tinue in the cur­rent en­vi­ron­ment,’ he says.

While mo­men­tum tends to per­form best in ex­pan­sions, it has also proved re­silient in slow­downs. Dur­ing the

sharp down­turn in de­vel­oped mar­ket eq­ui­ties in Fe­bru­ary, the rel­a­tive per­for­mance of mo­men­tum strate­gies held up well: mo­men­tum out­per­formed the broader US equity mar­ket by 0.1% and global eq­ui­ties by 0.64% dur­ing the eight worst trad­ing days.


Crit­i­cism of smart beta cen­tres on the grow­ing com­plex­ity of prod­ucts and dif­fi­culty in tim­ing switches from one strat­egy to an­other as mar­ket con­di­tions change.

‘In­vestors are hav­ing to be­come smarter to un­der­stand what they’re in­vest­ing in,’ says Justin Oliver, deputy chief in­vest­ment of­fi­cer at Canac­cord Ge­nu­ity.

He points to a tor­rid time for low volatil­ity ETFs dur­ing Fe­bru­ary’s down­turn. De­signed to suf­fer less in the event of a cor­rec­tion, many lost more than the broader mar­ket.

The prob­lem with smart beta is the reliance on past risk data and in­vestors chas­ing the lat­est fash­ion­able strat­egy in the same way they plough into ‘hot’ stocks or ‘star’ fund man­agers. For­mer low volatil­ity stocks tend to be­come more volatile as money flows into them and their val­u­a­tions in­crease.

Avoid­ing the herd men­tal­ity is one way around this sit­u­a­tion. ‘Ar­guably, the smart beta prod­ucts that should be of most in­ter­est to in­vestors are those that have per­formed poorly, be­cause they are more likely to come into vogue,’ says Oliver.

Di­ver­si­fy­ing across a range of fac­tors, ei­ther through a num­ber of stand-alone strate­gies or a multi-fac­tor fund, and tak­ing a long-term view are other routes to con­sider.

‘The key is time hori­zon,’ says Smith. ‘Most fac­tor strate­gies are ex­pected to play out over the longer term; this can mean ten years and be­yond. The chal­lenge in the short-term ob­sessed in­vest­ment mar­ket is to stick to strat­egy and not bail out at the first sign of un­der­per­for­mance.’

Oth­ers, how­ever, re­main ve­he­mently op­posed to so-called ‘smart beta’. ‘It’s not a smart bet; we don’t gam­ble with clients’ money,’ says Richard Stam­mers, chief in­vest­ment strate­gist at Euro­pean Wealth. ‘There may be a lot of these prod­ucts, but it doesn’t make any of them any good. It just means lots of peo­ple have jumped on the same band­wagon.’ (JH)

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