Smart beta strategies are designed to add value by systematically selecting, weighting, and rebalancing portfolio holdings on the basis of factors or characteristics other than market capitalization.
Investors who believed markets were largely efficient, or doubted their ability to select skillful managers, leaned toward low-cost market capitalization–weighted index funds.
Investors who believed markets were inefficient and had confidence in their manager selection process were more inclined toward active management.
Market cap–weighted equity index funds automatically increase their exposure to stocks whose prices appreciate and reduce their exposure to stocks whose prices depreciate. As a result, they tend to overweight overvalued stocks and underweight undervalued stocks, which can lead to an increase in concentration risk in exactly the wrong stocks!
Active management, unlike a rules-based objective strategy, is not transparent, comes with high fees, and often underperforms its benchmark over long time periods, especially when evaluated on a net-of-fee basis. Active managers with skill do exist, but are difficult to find. Typically, a great deal of time and resources are required first to identify them and then to monitor them over time. Moreover, when an active manager does outperform, the excess returns are often due to the manager’s style being in favor rather than to true skill. Indeed, the returns are reflective of those a “smart beta” strategy could provide at a much lower fee.
In practice, each of the choices investors can make-active or passive-has the potential to result in unwanted risks and disappointing returns.
The most important component of smart beta is breaking the link between the price of an asset and its weight in the portfolio.
Our research indicates that any structure which breaks the link between price and weight outperforms a cap-weighted index over the long run. Such strategies include fundamental weighting, equal weighting, minimum variance, and Shiller CAPE index. Breaking the link can be done simply and inexpensively and has been shown to have good historical efficacy in regions and markets all over the world.
Strategies that use market capitalization to select and/or weight securities, such as cap-weighted value indices, leave money on the table because of the return drag afflicting all cap-weighted strategies, and are not smart beta as defined by Research Affiliates.
At Research Affiliates, we believe the largest and most persistent active investment opportunity is long-term mean reversion. Our fundamental index approach systematically and methodically sells recent winners and buys recent losers. This regular periodic rebalancing flows naturally from our central belief in mean reversion—undervalued securities will ultimately rise to their normal valuation level.
The benefits of a passive strategy are all part of the fundamental index approach: transparency, low cost, high capacity, rules based, and systematic. Costs are kept low in both due diligence and monitoring, and portfolios are well diversified without stock, industry, or country concentrations.
When investors understand the investment philosophy, construction process, and return drivers around a strategy, they are more likely to understand why it may underperform over part of a market cycle. The transparent, rules-based nature of smart beta is simple to understand. In contrast, an active strategy may be more complex and less transparent, so that investors are less likely to understand why it may underperform over part of a market cycle. This often leads to poor decision making by investors who buy active strategies after a period of outperformance and sell them when they start to underperform.
Mean reversion is unreliably reliable and, as such, demands a patient investor. Prices revert to “normal” valuations at varying paces and over fluctuating time frames. When markets do return stocks to more normal valuations, the valuation may be the stock’s historical mean or a completely different level. Investors who commit to a smart beta strategy should do so with a 10-year horizon, and memorialize their rationale for future decision makers.
Rising valuations, above their historical normal levels, can artificially inflate past performance and reduce the future return prospects of a smart beta strategy. Higher valuations create an added risk of mean reversion down to historical valuation norms, threatening an abrupt reversal of past performance. An investor must look “under the hood” to understand how a strategy produces its alpha. Value-added can be structural—a plausible source of future alpha. Or it can be situational—a consequence of rising enthusiasm for, and valuation of, the selected strategy. Netting out the effect of changing valuations on past returns results in a more reliable estimate of a strategy’s true alpha-producing ability.
The fundamental index approach rebalances by selling winners and buying losers, a quintessentially contrarian exercise, also the wise council of the father of security analysis, Benjamin Graham. Investors considering this strategy need to be honest with themselves about their ability to persevere during periods of underperformance while they await the market’s recognition that their portfolio’s undervalued securities are indeed undervalued, and the market’s subsequent shift to value them consistent with their true underlying fundamentals. For most investors, a contrarian strategy is a diversifying strategy, selected as one strategy among several in their portfolio.
Obviously not every investor is a smart beta investor. For those who prefer to own the broad market, to pay next to nothing for market exposure, and do not want and/or do not have the resources to play a performance-seeking game, a cap-weighted index strategy is a sensible choice. The market is not always efficient, however, and a cap-weighted index can assume disproportionately heavy concentrations in companies likely to be overvalued and light allocations in companies undervalued relative to their fundamentals.
Today smart beta is often being viewed through the lens of risk and return drivers—or factors. These are investment characteristics that help explain the behavior of a security. Driven by risk preferences and or behavioral anomalies, factors have been shown to generate excess returns over long time horizons. Some factors are robust, whereas others appear to be the result of data mining.
Academic literature provides useful guidance on how to determine whether a factor truly contains a return premium.
The factor premium does not materially change because of minor variations in the factor definition or construction.
The factor is robust over time.
The factor works across geographies.
The persistent factor premium can be credibly explained, supported by
The equity factors that appear to be most robust over time and across countries are
Market Value Momentum Low Volatility
The metric and number of metrics used to define each of these factors can vary significantly across strategies.
The investment industry continues to evolve the concept of smart beta beyond the equity asset class. Commodities and fixed income are two of the more popular asset classes now attracting smart beta strategies.
Unlike in the equity space, weighting in traditional commodity indices are only loosely linked to price. These do however suffer from naive construction rules that lead to poorly diversified portfolios, negative roll returns and ultimately results in a return drag.
To improve on the performance of existing indices, smart beta commodity strategies tap into systematic sources of return, namely roll yield—both across different commodities and along the term structure of contracts—and momentum. These are the primary drivers of excess returns in commodity investing.
Traditional corporate bond indices weight their constituents based on the amount of debt outstanding. This means that the most indebted issuers have the largest index weights, potentially overexposing investors to firms with poor credit quality and high corporate leverage (based on debt to assets) without necessarily improving returns.
Sovereign bond indices are weighted by the market value of outstanding debt, where countries with the most debt receive the largest weights. The quality of these debts and the countries’ ability to service and ultimately repay them, is often not proportional to the size of the debt burden.
Applying the principles of smart beta to fixed income means emphasizes debt-service capacity, severing the link between outstanding debt and portfolio weight. This approach avoids overexposure to companies or countries with high debt burdens and credit risk.