Evolution of the Smart Beta Strategy: Is Smart Alpha Next?

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A number of developments in the financial sector paved the way for smart beta investing, including the rise of indexing and factor investing. The smart beta market has exploded onto the investing scene but is still finding its feet, with some predicting a morph into ‘smart alpha’ strategies.

Smart beta strategies are rules-based and use alternatively-constructed indices to target risk factors. Since they employ long-only positions and are defined by sets of rules, they can be appropriate vehicles for Shariah-compliant funds.

Smart beta, or custom indices as they are sometimes known, can assign different weightings to the stocks of usual benchmark index funds like the S&P 500 Index. They can also be compiled by selecting stocks which fit a strategy’s stock-selection rules, including exposure to a desired investment factor (low volatility, for example). Though they are passive investment strategies, they carry an active slant.

While benchmark indices such as the S&P 500 offer investors exposure to the equity market factor (or beta), the most common alternative factors targeted by smart beta include value (targeting underpriced stocks), size (small stocks), growth, momentum and low volatility.

The origins of smart beta – from factor exposure to indexing

The value factor dates back as far as the 1920s and 1930s, though it was only formalised decades later. According to index provider MSCI, Rosenberg and Marathe, in their 1976 paper, were among the first to define the value, growth, size and momentum factors as determinants of investment returns.

Later, in the early 1990s, Fama and French added the size and value factors to the capital asset pricing model (CAPM). CAPM had previously only included market exposure as a key driver of equity returns, and as such, Fama and French’s Three-Factor Model was well received in the market.

A wide array of other factors have since been identified and targeted by portfolio managers and investors.

Meanwhile, the first index fund was introduced in the 1970s, based on the premise that exposure to the broad market offered better returns than most active managers could muster. Part of the attraction to investors was the passive nature of indexes, which also meant lower fees.

The next major development was the launch of exchange-traded funds (ETFs), which track indices and which are tradable on stock exchanges. The first ETF, called Toronto 35 Index Participation units, was launched in Canada in 1990. It gave investors exposure to the Toronto Stock Exchange’s TSE 35 Composite Index (a proxy for beta exposure) without the need to buy each underlying share.

ETFs are essentially types of index funds, which in turn are types of mutual funds (a mutual fund holds and manages a portfolio of assets on behalf of investors).

One risk associated with index funds is that they can become heavily weighted towards stocks or sectors which have been through a boom period. When bubbles burst, as was the case with tech stocks at the turn of the millennium, these indices risk heavy losses.

Some smart beta strategies can offer a degree of protection against these and other investment risks. Equally-weighted indices, for example, avoid tilts towards certain stocks or sectors.

Passive investing has been growing ever since indices and ETFs were launched, and has recently been given a major fillip by the smart beta niche. Smart beta has become a driving force within the world of index investing, partly because it can be used for risk management in addition to targeting factors which offer superior long-term performance metrics.

Smart beta is helping passive fund management eat into the dominance of active management strategies. Smart beta funds are measured against their benchmarks, with returns adjusted for risk when evaluating performance.

Future developments in smart beta

Naturally, a number of portfolio managers and market commentators call the next step in smart beta’s development ‘smart alpha’.
refers to excess returns over what the market delivers, which can stem from skillful stock selection or superior investment strategies.

Some believe smart alpha strategies will be a form of ETF which replicates hedge funds, while others believe the next logical step is to create a framework that is more active and forward-looking than smart beta in its current form, potentially at the expense of transparency.

But others caution against smart beta strategies becoming too complex, partly because the attraction in the first place was that they adhered to simple rules and were highly transparent.

Smart beta funds are created from quantitative research and analysis, which means any developments in the ‘quant’ world will help drive the semi-passive smart beta industry.

Meanwhile, one strategy which uses both passive and active approaches is the portable alpha strategy, which adds an alpha layer onto a beta index.