Adam Berger, CFA Asset Allocation Strategist
Conor McCarthy, CFA Director, Client Investment Solutions
Wellington Management
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Institutional investors could be forgiven for rolling their eyes at yet another article on “smart beta.” Indeed, the hype around this topic over the last few years has been intense. Smart beta products seem to launch daily, webinars on the topic are offered weekly, and papers roll out monthly. Proponents of smart beta argue that it is the new cure-all. Replace your passive managers! (Solve the problems of cap-weighted indexes.) Replace your active managers! (Solve the problems of high fees.)
We believe that smart beta will follow a path similar to other strategies that once promised to revolutionize portfolio management. What does this path look like? A handful of strategies will be great successes, enhancing investment outcomes for the pioneers who embrace them. A much wider range of me-too strategies, attempting to ride the coat-tails of the latest trend, will leave behind a trail of disappointed investors. But even if smart beta products disappoint, eventually many of the key underlying ideas will have a lasting impact on the way institutional investors manage portfolios. This makes the key concepts behind smart beta important — even for those who will never buy the products being hawked so aggressively today.
Smart beta basics
The key insight of smart beta is that strategies built around factors such as value, momentum, carry, and low volatility can offer attractive, sustainable expected returns that diversify the returns from a traditional portfolio driven by the performance of stock and bond markets.
Yet many smart beta approaches are constrained by being long-only, limited to equities, and focused on a single factor. Such approaches may eventually outperform traditional cap-weighted indexes. But with only modest risk-adjusted excess returns (information ratios), they are likely to suffer short periods of sharp underperformance and protracted stretches of flat or negative excess returns. Hence, their long-term results net of transaction costs and fees are likely to disappoint — even if the latter are modest.
Smarter than smart beta
Strategies that transcend the limitations of basic smart beta hold greater promise. For example, long-short approaches that seek to isolate specific factors without incurring market exposure have compelling diversification potential. Strategies outside equities, notably within fixed income, offer the possibility of outperforming widely followed indexes that often bear little relation to the goals of the investors who use them. Lastly, approaches that combine multiple factors have strong potential to deliver better risk-adjusted returns than single-factor portfolios. We believe this potential is best realized in integrated approaches that combine multiple factors, where unintended risks can be mitigated by the manager at the portfolio level, rather than in an uncoordinated grab-bag of single-factor strategies.
Another major step in moving beyond basic smart beta is to acknowledge that any strategy deviating from a market-cap-weighted index is inherently active. This means investors should beware of “index-like” smart beta strategies that seem to dominate the space. Indexes are based on a clear set of construction rules that are transparent and static. But these are not desirable characteristics for active strategies. Transparent rules mean that others in the market can learn and take advantage of your positioning. Static rules mean that the investment process can’t adapt to changing market conditions or crowded trades. (Although smart beta is sometimes compared to traditional quantitative equity or to the “enhanced index” strategies that gained popularity in the early 2000s, those approaches typically benefit from dynamic portfolio management by a team of specialists who continuously review and refine their models — and neither approach publicizes its investment model for all to see.)
Investors who acknowledge that smart beta strategies are active approaches are more likely to focus on strategies that incorporate some degree of active skill, whether that comes from better or more differentiated factor definitions, implementation improvements in areas such as trading and transaction cost control, forward-looking insight, or better portfolio construction through risk management or factor timing.
Putting smart beta concepts to work
Amidst the cacophony of voices opining on smart beta, it’s easy to forget that most investors pursuing the strategy are trying to accomplish one of three simple goals:
Enhance returns in a world of diminished expectations. The biggest bang for the smart beta “buck” may be in fixed income or commodities, where we believe traditional benchmarks are often mis-aligned with investor objectives.
Improve transparency or reduce costs. Consider replacing or complementing relatively costly, opaque hedge-fund strategies with factor-driven alternative beta strategies that offer more efficient access to many of the key drivers of hedge-fund returns and differentiation.
Improve portfolio construction and risk management. Thoughtfully constructed low-volatility strategies — those that are conscious of sector risk and don’t rely on unintuitive, over-engineered optimizations — may be useful. Or, investors can adapt the ideas underlying smart beta to improve their current portfolios. This is the investor objective where we think smart beta will ultimately have the biggest impact — that is, once managers stop launching products or writing papers (sorry!) and allow their clients to actually consider what the key ideas mean.
Because factors are important drivers
and determinants of portfolio performance, investors should build portfolios that are well diversified across those factors. Moreover, since factors — like markets — tend to go through up and down cycles, investors can use factor analysis to add value through active rebalancing or strategy timing.
Our take-away advice to investors is to look beyond smart beta. Stop reading papers, ignore most of the new products coming out, and focus on what these ideas mean for your portfolio and objectives. In today’s challenging investment landscape, you might uncover a few nuggets of hope buried beneath the hype.
To learn more about our research on this topic, visit https://www.wellington.com/beyond_smart_beta