Smart beta equity strategies have the potential to outperform the broader equity markets. If naively constructed, though, they may also offer some unpleasant surprises. In fact, many of the smart beta approaches in the marketplace today may not deliver quite what investors are expecting.
Smart beta represents a form of what is known as factor investing, which for decades has been a focus of quantitative active management. Smart beta strategies typically provide exposure to a specific fundamental stock characteristic, such as value or momentum, and they are deliberately narrow in scope. Although such a strategy can be useful in some situations, investors should realize that, by definition, such portfolios are not making use of all available information. This sort of allocation approach can be problematic.
The appeal of single-factor strategies is that they, as the name suggests, are simpler than multifactor approaches. The attraction to simpler-is-better can paper over hidden risks. For example, investors may attempt to assemble suites of single-factor portfolios, each designed around a different component. This tactic is promoted as a customized form of exposure, but the mix of exposures that may seem optimal looking at the portfolio as a whole can create messy interactions at the stock level a perspective most smart beta investors fail to see.
Consider a value portfolio, which might well have many stocks with bad momentum scores. Alongside it is your momentum portfolio, which could easily have stocks with bad value scores. When combined, these two portfolios have constituents with characteristics that fight against each other. Which stocks should stay, and which should go? This question is something that an active quantitative manager should be good at deciding. Depending on the particulars of the funds construction, however, factor conflicts may be impossible to address when using prefabricated smart beta sleeves.
Simplistic smart beta portfolios can also have accidental exposures to such fluctuations as currency movements, interest rates and oil prices. Even their equity betas their tendencies to amplify or attenuate the returns of the broader equity market can vary dramatically over time. Risk exposures such as these can be addressed, though they are much easier to monitor and control in a multifactor approach. Optimal smart beta portfolios should be free to include all available information about stocks, including information about both future risks and return potential.
The vehicle you choose, in other words, is important. Remember, smart beta is not a form of passive investing. It explicitly rejects cap-weighted broad-market indexing. We at Acadian Asset Management view the decision about how to diverge, even if via a rules-based, transparent strategy, as an active call.
Many smart beta strategies are designed to emphasize distribution potential, with implications that are not always desirable. The emphasis on scalability puts a premium on qualities such as simplicity of investment thesis, process transparency and liquidity. Such product characteristics have superficial appeal, but they are often accompanied by costs and risks, including lost alpha, unintended exposures and implementation drags. Index funds are also highly susceptible to front-running, as they typically telegraph their intended rebalance activity well in advance of trading.
Even with all these considerations, some applications of simplistic smart beta allocations can make sense. One example is a completion portfolio. Smart beta can help when an active equity manager is under- or overweight particular factors or stock level characteristics. In these cases, smart beta can be bolted on to complete the equity allocation. It can also be helpful to measure the share of active returns that are explained by simple and cheaply replicable factor exposures, as opposed to true alpha from active stock selection.
The key takeaway here is that smart beta is not simple. Investors should think carefully about how they are using it and be aware of the risks that may not be readily apparent. In our view, active management is necessary to gain the full advantages of this type of allocation. Only a considered approach that uses all available information can deliver factor exposures that are balanced, risk-controlled and free from unintended bias.
Ryan Taliaferro is senior vice president and portfolio manager at Acadian Asset Management in Boston.