Taking the dumb out of smart

Do you remember school days? To be fair, it’s been a while for me.

There was always somebody first with their hand up or the first with a ‘clever’ retort to the teacher. We used to call them smart alecs (or something similar). These were not compliments.

And yet, today anything with smart put in front of it is cutting edge, something new and clever. Think smart phones, yes, smart TVs, yes again, and smart motorways, hmmm ...

So what about smart beta?

Smart beta uses different factors than the typical market-cap weighting to construct a new index for a passive portfolio to mirror. So why so smart? If these rules are poorly constructed, then it could still be dumb beta, just in a different way!

When I think of smart beta I think of index-based investing with either a derivative overlay to modify the outcome or rule-based factors added to constrain an index. Derivatives can be added to an index to enhance the return with added risk (gearing) or reduce risk by hedging the downside. I use both of these in the equity-risk component of my strategies at the moment, as I believe global indices may well post very modest returns over the next year, given current valuations. In some cases these derivatives can generate high single-digit returns even if indices fall.

So smart beta is a no-brainer? Well, no. As always, investment products can get launched to play to a hot theme or to mitigate a past risk. Most rule-based investments are based on historic data. Providers will argue these passives are forward looking, but they are still anchored on historic experiences and can suffer from this lack of flexibility. I would argue that what makes humans smart is the ability to adapt to our surroundings. A smart beta index doesn’t have this luxury.

The list of potential smart beta indices is endless: thematic ETFs focused on renewable energy, robotics or water; equities with greater dividends or low debt to equity ratios; bonds with specific duration or those with high interest coverage etc.

Like any other form of investing, however, there will be some that stretch the definitions. Think tech in 1999: if Marks and Spencer launched a website it got re-rated as a tech stock! Exaggeration? Maybe, but only slightly.

Overall, the rise of varied index construction is a good thing. Investors are able to get relatively cheap exposure to specific market factors like never before. Instead of making do with expensive active management that may not do what is needed or cheap and blunt exposure to the largest companies on a stock exchange, you can choose from an array of different passives.

However, I believe these new indices and strategies must lose their misleading smart moniker. Alternative beta is a much more accurate term. Investors need to remember that they have to provide the investment smarts, an index won’t do it for them. Take a good look at alternative beta products to find out what you’re buying and keep tabs on how the portfolio and its performance changes over time.

The most important thing to remember is that these products have subjective judgements built in and we know how reliable they can be…

 

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