How smart is ’smart beta’?

There tend to be three sorts of investors in fund management. At the cheaper end of the spectrum are the passive ones who simply track the market index (‘beta’ in the parlance). At the more costly end are active investors who seek ‘alpha’ (a return in addition to the beta of the market). The third type is known as ‘smart beta’ – they believe it’s possible to get the best of both worlds through a low-cost passive approach with the ‘brains’ of an active manager. But as with most things in life, should you expect to get what you pay for when it comes to managing your investments?

Passive investment is the cheapest, but might not get the best returns. For example, if you are tracking the FTSE 100, the index is based on market capitalisation (share price times number of shares publicly traded), so constituents are chosen (and deselected) according to their size. That means trackers could be passively buying high and selling low, which would be counterintuitive. Of course, if managed right, trackers should follow the index which tends to rise over time. The question for active managers is, can they deliver enough alpha to justify the additional cost? Is there a sweet spot that can deliver better returns at a lower cost than the typical active strategy?

There are a host of smart-beta strategies focused on market-beating anomalies, aiming to outsmart the index at low cost – sounds perfect, right?

Assets managed by smart beta have grown quickly; current AUM exceeds $1 trillion, driven by common strategies employing what’s known as a single-factor approach. These are typically equity strategies that seek to systematically remove the strongest performers and add any laggards perceived as cheap. Some of the more established factors are value, momentum and volatility, and data are analysed constantly to uncover new factors.

How accurate are the alpha-generating claims of smart-beta managers? They too need to justify charging fees beyond those of index trackers. In a sense they are seeking to exploit persistent anomalies. They do exist, but certain smart-beta factors require a conducive economic environment, or they may suffer long bouts of laggard performance, which means an increased risk of selling at the wrong time.

Take popular high-quality defensive strategies as a case in point. These have been rewarded by extraordinary returns, but are investors mistaking a fortuitous trend for genuine and sustainable alpha generation?

The MSCI World quality factor rallied about 40% from the beginning of 2017 to its October 2018 high, but fell sharply during the bout of volatility into the end of last year. This factor is defined by return on equity, debt to equity and earnings variability, but it ignores valuations.

The high valuations exhibited by stocks with these high-quality defensive factors left them vulnerable. If their valuations revert to longer-term averages, smart-beta investors tracking these factors could be facing a reversal of their performance gains relative to the index (i.e. their alpha might prove elusive). Expensive valuations may also make them susceptible to outsized losses in the event of a systemic shock. 

As a buffer against such political and economic shocks, the qualities a discretionary fund manager (DFM) can bring include emotional fitness, support from a highly ranked research team and the professional skills necessary to ensure portfolios are managed to accurately reflect both client need and market conditions.  Bespoke portfolios are not just another luxury item for the well-off.

Knowing which active managers to choose, and avoiding the pitfalls of over-diversification by having too many, can be challenging. Again, a closer relationship with a trusted DFM can help.

Photo by Sean Patrick Murphy on Unsplash.