To view a PDF of the full report, click here. By Jennifer Bender, PhD
Head of Research for Global Equity Beta Solutions, State Street Global Advisors
What’s driving the interest in Smart Beta?
There are two big trends driving interest. One is that we’re living in a lower-for-longer return environment. Investors across the board are going to have more challenges achieving their investment objectives when the equity risk premium is expected to be near low single digits. So they need to make their risk budgets and manager fees work harder to reach their goals. That has implications for how they are structuring their portfolios and their expectations of high-fee active managers.
Secondly, looking at portfolio diversification in a way that goes beyond asset class labels to understand the underlying risk drivers of return has provided a powerful lens for building more capital-efficient portfolios. The tools have improved significantly over the years to help investors better understand how much of their active return is coming from true, skill-based alpha, and how much from a risk exposure that can be replicated in a more cost-efficient Smart Beta strategy. This is why Smart Beta is upending traditional active management and raising the bar on active managers to demonstrate their value-add.
How do you define Smart Beta?
While Smart Beta has become a popular marketing term over the last few years, it is important to note that it is part of a broader discipline of factor-based investing, which is really revolutionizing how investors think about building portfolios. Factor investing is grounded in years of academic research and covers a wide spectrum of approaches and applications. It is based on the principle that there are systematic factors such as size, valuation or momentum that deliver a durable premium over the long term versus a market-cap weighted benchmark.
Smart Beta provides a rules-based, transparent way for investors to capture the well-documented factor risk premia across equities and fixed income. For many investors venturing into factor investing for the first time, tilting to one or more of these Smart Beta factors in their core passive exposures is a way to target incremental returns in a highly fee-productive way. Our ETF structures also lend themselves well to these types of Smart Beta approaches for a broader base of investors looking for a liquid and low-cost way to express these factor tilts.
But Smart Beta is just an entry point on a continuum of factor-based approaches that go beyond stocks and bonds and involve a variety of techniques at both the asset class and the total portfolio levels. Moving along that spectrum, investors can find very sophisticated ways of specifying factors, managing them through time on both the long and the short side and pursuing real skill-based excess returns that can rival those of hedge funds but for lower fees. So Smart Beta as a label is much less important than understanding how a manager is implementing a particular factor investing strategy.
If the empirical evidence around factor investing has been around for years, why haven’t all investors already switched to this approach?
You could argue that the style box approach was an early expression of factor investing insights. But this current wave of more explicitly building portfolios around factor risk exposures rather than asset classes alone represents a significant shift away from traditional investment models and mindsets. That kind of change takes time and education, but the challenges posed by markets are prompting more investors to reconsider business as usual. State Street Global Advisors is particularly well-positioned to guide clients through this transformation as our investment heritage was built on a foundation of systematic, factor-based methodologies. Today we are extending that core expertise and developing the next generation of active, factor-based strategies, leveraging insights from big data and new analytic tools, and aiming to revolutionize the investment management industry as we know it.
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Among the factors that the strategy considers is momentum. This emphasizes investing in securities that have had higher recent price performance compared to other securities, which is subject to the risk that these securities may be more volatile and can turn quickly and cause significant variation from other types of investments. Factor-based investing also considers the value factor. A value style of investing emphasizes undervalued companies with characteristics for improved valuations, which may never improve and may actually have lower returns than other styles of investing or the overall stock market.
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