Smart beta: a third approach
‘Smart beta’ investing is rapidly becoming a popular alternative to both conventional passive management and traditional active management.
An active approach involves investing in a portfolio of high-conviction concentrated stocks with the aim of outperforming the broad market index.
Passive approaches invest in indices where component stocks are usually weighted by market capitalisation, meaning larger companies will have greater representation than small and mid-cap companies.
We call smart beta a third approach because it blends the best features of active and passive investing.
It combines the simplicity, transparency and low cost of passive investing with the aim to outperform market capitalisation-weighted indices from active investing.
Smart beta indices or portfolios are weighted not by market capitalisation, but by other drivers of returns. These factors are company characteristics such as the value or size of a company.
For example, the quality factor weighs companies by their financial strength and the stability of their balance sheets, and the low volatility factor weighs companies inversely to their riskiness relative to the market (low volatility companies have a higher weight than higher volatility companies).
Some of these factors have been shown to outperform the market capitalisation indices over the long term.
Smart beta aims to gain exposure to these factors in an efficient and systematic (rules-based) way in order to outperform the market.
How do we define which factors are important?
Clearly not all factors should be included in a smart beta approach. At Aberdeen Standard Investments (ASI), we look for ‘Smarter’ factors. In order for a factor to be included in our investment process it must be a RIPE factor:
- Robust – Factor premia must perform effectively in a constantly changing environment
- Intuitive – Factor premia should behave as one would expect
- Persistent – Factor premia returns will be cyclical but show persistence and generate excess returns over the medium to long term
- Empirical - Factor premia should be based on or supported by empirical academic research that explains a reasonable basis for the existence of a premium
Factor premia arise in financial markets in two ways.
Behavioural anomalies lead to mispricing because investors have mistaken beliefs, incomplete information, or non-rational preferences.
Structural anomalies lead to persistent mispricing because there are limits or costs to arbitrage that prevent it from being bid away.
At ASI, we have been involved in factor investing for over ten years and we have a strong track record. We invest in five factors – value, quality, momentum, small size and volatility and integrate environmental, social and governance (ESG) into our investment process at both the universe construction and portfolio construction phases.
This incorporates considerations around the quality of company management, governance issues, how the company treats its stakeholders and so on.
However, we do not yet believe ESG is a RIPE factor due to the short history of ESG data.
We access individual factors by investing in a large variety of stocks that exhibit that factor, rather than one specific stock. This way, we can reduce stock-specific risk and diversify away exposure to other factors.
Over the longer term, smart beta approaches have outperformed relative to a passive market cap approach, as Chart One shows.
The multifactor approach performs the best followed by the small cap factor and value approaches. The quality factor has performed the worst of the smart beta approaches but it still outperforms the market cap index.
But the chart doesn’t show the variation in performance of factors each year.
The chart below shows the performance of each of the five factors in every year since 2006 with the best performing factor for each year at the top and the worst performing factor at the bottom.
For example, the minimum (or low) volatility factor is in light blue and the chart shows this factor performed well during 2014-15 but less well in the two years since.
So while smart beta factors may outperform in the long term individual factors can underperform in any one year. Therefore, trying to time factors is as difficult as trying to time the equity market.
The approach we advocate is therefore a multifactor approach, which equally weights the portfolio to all the factors at the same time.
In this way, we are benefitting from diversification which smooths performance and reduces the timing risk of each factor.
Smart beta is expected to see rapid growth in the coming years.
Spence Johnson, the research and data provider predicts that smart beta will, along with exchange traded funds, be one of the fastest growing product areas with 11 per cent year-on-year growth globally projected over the next few years.
Why is this?
We believe there are five forces underpinning the future growth of smart beta:
Post-global financial crisis regulation which has encouraged increased transparency, simplicity and fee scrutiny;
Increasing recognition of the flaws of traditional market cap-weighted indices and a consequent focus on alternative weighting schemes;
The low return environment which has heightened focus on the costs of active management. Here, smart beta offers value-for-money products that are especially attractive to defined contribution schemes;
Changing investor behaviours, and an increasing sophistication and demand for solutions in particular. Smart beta offers outcome-based products and solutions, such as low volatility or ESG-tilted products, for example; and
Technological innovations including the rise of Big Data, the Internet of Things, artificial intelligence and machine learning. These advances enable smart beta to deliver returns in a very scalable and cost-efficient manner.
It’s therefore a great time for investors to consider investing in smart beta.
Boyan Filev is co-head of Quantitative Equity at Aberdeen Investment Management.
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