Smart beta came into play around 50 years ago when advisers looked for an alternative to the market cap-based indices approach. Since then, technology and industry competition has risen and it’s a whole new ballgame, Hope William-Smith finds.

It’s hardly surprising that advisers, fund managers, accountants, and insurers are constantly searching for new sources of return as the country swells, the population ages, and investment options continue to expand.

When smart beta strategies come into play in the 1960s across a range of traditional and alternative asset classes, the majority of the focus lay in the equities space.

Since the Global Financial Crisis (GFC) however, those strategies have generated new interest from institutional investors and have moved from theory to implementation.

Experts have agreed there are many labels used to describe the smart beta world but State Street Global Advisors (SSGA) head of global equity beta solutions, Susan Darroch, said each should display the common characteristics – transparency, rules-based repeatable, and low cost. Smart beta is effectively a new name for an old meaning.

“It’s important to get an understanding of how the product is constructed, what exposures are being delivered, the benefits and the shortcomings of the methodology and what are the alternatives that are available, to determine which best suits your risk tolerances and requirements,” she said.

“Know what you are buying, and be on the lookout for the sheep dressed as a lamb.”

Industry education

Described by BlackRock head of wealth – iShares, Alex Zaika as “the marriage of active and passives”, smart beta strategies preference alternative index construction rules rather than traditional market capitalisation-based indices.

According to Capital Fund Management head of Asia-Pacific, Steve Shepherd, smart beta described “a set of investment strategies which try to deliver a better risk/return trade-off than that offered by conventional market capitalisation weighted indices, by using alternative weighting schemes based on different factors”.

“Smart beta aims to give a better Sharpe ratio than the traditional market-capitalisation based beta that we are familiar with – the primarily long-only investment strategies,” he said.

“Smart beta strategies rely on long-only portfolio construction rules, which means that if there are difficult periods for equities, these same periods will also be difficult for smart beta portfolios.”

Shepherd said the first step for fund managers was to build their smart beta knowledge. He said it was important to know how beta strategies could fit within a portfolio and to be able to answer adviser concerns on client needs.

“What’s important to understand is the purpose of what each strategy is and what you are trying to achieve in your portfolio by using one,” he said.

“We rely on markets because we trade in them, [so] our strategies are designed to trade in such a way that they are truly de-correlated.”

Despite the age of smart beta strategies, SSGA global portfolio strategist, Asia-Pacific, Thomas Reif said smart beta used within a portfolio still required specialist knowledge and extra effort to understand the expected investment experience.

“Not all managers have the breadth and scale to implement these strategies effectively on a global scale,” he said.

“Finding the right partner on your factor journey can be challenging – investors can rely on a systematic and consistently applied approach to deliver the return expectation without surprises.”

In the adviser space, more attention would need to be paid to ensure Future of Financial Advice (FOFA) obligations were met.

“There are some in the industry that view smart beta as a real threat and those that view it as a threat are probably those that have charged relatively high fees and perhaps haven’t delivered on their stated objectives,” Zaika said.

“Those that would not view it as a threat would be those managers who have been able to deliver on their objectives and investors will continue to support those.”

Zaika said advisers had the opportunity to educate themselves around the “current buzzword”, but it remained less popular for advisers than those in funds management circles.

“Dealer groups [are] starting to really pay attention and focus on smart beta strategies and approving them for advisers to use for client portfolios,” he said.

“For some advisers, this term ‘smart beta’ is relatively new and an adviser can’t recommend a strategy or solution unless they really understand it themselves.”

Despite this, Reif said fund managers and advisers could win over investors if their knowledge was up to scratch.

“Investors may not appreciate how transparent and simple smart beta strategies really are – there’s an investment in education to see the benefits,” he said.

“Many investors find comfort in an evidence-based approach to investing that has shown to work in a global universe though time.”

Portfolio construction

When building a smart beta portfolio, Darroch said care needed to be taken to follow the pedagogy of the strategy in question.

“A smart beta portfolio should be giving exposure to a particular factor, or factors, in a simplistic and repeatable way. The factors that have the deepest academic support include value, volatility, size, quality, momentum and yield,” she said.

VanEck managing director, Arian Neiron encouraged fund managers to look at the specificities and trends within the market to best gauge risk/return.

“Look underneath the bonnet of that smart beta. If you’re targeting equality factors or factor-based investing you know you’re going after companies and stocks that can ride the economic cycles,” he said.

“You’re looking at companies that can effectively weather the storm in a drawdown event or in a market crisis and they’re going to typically do better than stocks that are highly leveraged.”

Shepard said fund managers would be able to best predict fluctuations within the market and their effect on portfolios which employed smart beta strategies by knowing the construction rules and keeping an eye on equities.

“Smart beta strategies rely on long-only portfolio construction rules, which means that if there are difficult periods for equities, these same periods will also be difficult for smart beta portfolios,” Shepherd said.

“Everything is long only, value/growth, quality, or momentum strategies, and therefore the portfolio can be both transparent and easy to understand because it is closely linked to the performance of the underlying stocks.”

Knowing your numbers

The actual “how to” of smart beta was a complex process when it came to lining up with investors’ goals, Zaika said.

“If they are trying to outperform the market, they should look for a smart beta strategy that utilises the investment style or investment techniques that are being proven over long periods of time to deliver outcomes,” he said.

“An investor may be approaching or have just entered retirement and rather than trying to outperform the market, they’re trying to reduce risk. In that case, an investor may consider looking at minimum volatility or low volatility, so having equity like returns, but with much less risk in their portfolio.”

In a market environment with intense fee pressures, a low cost, active return from highly diversified portfolio would remain a compelling proposition for investors, to place the newly-coined term “smart beta” well on the way from fad to investment fashion.

“More and more we see investors view smart beta as a passive implementation of an active approach,” Reif said.

“This allows fees to be kept low, while delivering an active return.”

With use of smart beta strategies on the rise, Neiron said the only roadblock ahead was a fiduciary hesitance at following a trend which had the results, but lacked the longevity of other more reliant portfolio strategies.

“You’re going to see a natural apprehension,” he said.

“A lot of advisers are still getting their heads around what this approach, in terms of portfolio construction, is really all about.”

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