Smart beta is not a fad and demand is growing quickly within equity investing and beyond, Jon Howie explains.
Over the past year, a growing number of advisers have started to get questions from their clients about smart beta.
Helping clients understand what smart beta is, and how it can be used in their investment approach, is becoming increasingly important. While it may originally have been dismissed by some as a fad, or simply the latest buzzword, smart beta should in fact be viewed as a better way to access the true drivers of portfolio returns.
A better understanding of smart beta is a good first step in developing tailored and flexible portfolios that will help clients achieve their long-term aims.
Explaining smart beta
At the heart of smart beta strategies are factors, which have been used for years by institutional investors and active managers to build portfolios and pursue returns.
Put simply, factors are time-tested sources of returns within and across asset classes.
Investors have long sought to better understand what drives returns. Over time, clear and persistent drivers of investment returns have emerged. By the 1930s, academics and practitioners started to systematically identify these drivers of returns, which became known as ‘factors’.
While the concept of factors isn’t new, the use of factors is being revolutionised by technology. Advances in financial analytics mean large amounts of market data can now be screened with blinding speed, allowing factors to be isolated and utilised with greater precision, and making factor investing an increasingly attractive approach.
Types of factors
There are two main types of factors – macroeconomic and style factors.
Macroeconomic factors, such as the pace of economic growth and inflation, can explain returns across asset classes like stocks and bonds. For example, strengthening economic growth can boost stock prices while rising inflation can drive bond prices lower.
These factors capture broad risks such as those associated with economic growth, real rates, inflation, credit, liquidity, and emerging market factors, and our research suggests they explain over 90 per cent of asset class variation.
Style factors, on the other hand, help explain excess returns within asset classes. These include value, momentum, quality, size (market capitalisation) and minimum volatility. For example, within equities, value stocks – which have low prices relative to fundamentals – have historically outperformed the broad equity market over the long-term.
These factors explain risks and returns not just in equities but also fixed income, commodities, currencies, and even private markets such as private equity and real estate.
Individual factors are typically driven by different market phenomena and therefore tend to be rewarded in different market environments and economic cycles.
Many clients already have exposure to factors, even if they don’t know it.
Active managers have long recognised the impact of underlying factors on market returns and, as such, they tend to invest in securities that capture certain factors. For example, to gain exposure to interest rate or value factors, they may adjust holdings in anticipation of a rise in interest rates, or evaluate balance sheets for potential market mispricings.
While most smart beta strategies available today invest in stocks, this is changing. The same insights can be used to seek enhanced risk-adjusted returns versus market-cap benchmarks in fixed income and other asset classes.
So while the notion of factors themselves is not new, factor-driven investments have become more widely available to investors in the form of smart beta strategies.
Why ‘smart beta’?
‘Beta’ has traditionally represented broad market exposure based on market capitalisation weights. ‘Alpha’, on the other hand, measures the performance of an investment against a market index used as a benchmark.
Like traditional beta strategies, smart beta strategies also use rules-based indexes, but seek to outperform traditional benchmarks by targeting exposures to one or more factors. Investing in factor-driven indexes through smart beta strategies can provide opportunities to seek improved returns, reduced risk or enhanced diversification.
Whether they use a multifactor or a single factor approach, smart beta strategies give investors the potential to fine-tune their exposures and reduce unintended risks. As a result, using these strategies can result in a more deliberate allocation to potential sources of risk and return.
For instance, there are smart beta strategies that are constructed with the goal of reducing risk. These ‘minimum volatility’ strategies have historically delivered market-like returns with less volatility by targeting lower volatility stocks.
Well-designed minimum volatility strategies will take into account the correlations amongst stocks and will have guardrails in place to limit sector and country concentrations. Minimum volatility funds have historically lost less during market declines but have still captured meaningful gains during market upswings.
These minimum volatility strategies are designed to work best during periods of market volatility and over the long-term.
Likewise, multifactor strategies are optimised to provide diversified exposure to several factors. Individual style factors may zig while the others zag, depending on the market environment, so a portfolio that uses a multifactor approach can potentially benefit in a variety of market conditions.
Over the long-term, combining factor exposures may produce even more consistent results than factor exposures individually.
Multifactor equity funds can be structured to have sector, country, and risk characteristics which are similar to well-known equity benchmarks, so these funds can function as long-term core allocations.
Implementing smart beta
There are two ways that advisers can help clients implement equity smart beta strategies in a portfolio – either as a strategic longer term allocation or as a tactical allocation to express an investment view.
When complementing existing holdings, investors may consider multifactor strategies to enhance returns. They are designed to be part of a client’s long-term core holdings.
Because of low correlations among factors, multifactor funds have the potential to offer more consistent returns over a market cycle and higher risk-adjusted returns.
Multifactor and single factor funds can also complement each other. For example, a minimum volatility fund can reduce the overall risk of the portfolio that also has a multifactor fund, which aims for outperformance over a full market cycle.
Smart beta strategies can also act as a substitute for low-risk active strategies, retaining the potential for incremental returns while increasing transparency and lowering costs.
Targeted factor exposures are now also widely available to individual investors through exchange-traded funds (ETFs).
Understand the choices
There is a wide range of smart beta options for clients to choose from, and due diligence is critical. Smart beta strategies may seek the same investment outcome, but they may vary in efficacy.
Questions that investors should ask include: Which smart beta strategy will best deliver its intended investment outcome? Will the smart beta strategy further diversify my portfolio or will it simply compound unintended risk?
Among the primary considerations, the index construction rules governing smart beta strategies are crucial. Similar sounding strategies may produce different results.
Smart beta checklist
The checklist in the table below breaks down the primary considerations for investors into three pillars – a strategy’s purpose, outcome and management.
Smart beta ETFs
Smart beta ETFs make factor investing a low-cost and tax-effective approach to investing. We believe that smart beta ETFs can potentially improve investment results, both as tools to seek incremental returns and reduce risk, and as ways to enhance transparency and lower costs.
Smart beta provides investors with a blend of active and passive investing, often delivering many of the themes present in active portfolios at a fraction of the cost.
The demand for smart beta is growing quickly within equity investing and beyond. The next generation of smart beta ETFs will likely include more fixed income and alternatives, and improve the way factors are combined to target investment outcomes.
Jon Howie is head of iShares Australia.