Smart Beta Strategies: Victims of Their Own Success in the Long Run?

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Since the first smart beta exchange traded fund (ETF) was launched in 2003, the number of these products available to the market has exploded as investors search for low-fee alternatives to active fund management. Investors worldwide are
harvesting the benefits of both smart beta and risk premia strategies.

Smart beta offers an active slant on passive index-tracking investment strategies, with the aim of lowering costs and beating the market – in other words, achieving alpha. Fees tend to be only slightly higher than those attached to a benchmark index tracking fund.

New York-listed ETF management firm BlackRock predicts that the global value of smart beta ETF assets will grow from US$282bn currently to $1 trillion in 2020 and $2.4 trillion by 2025. This rapid growth, of 19% a year on an organic basis, will easily outpace broader ETF markets and will be driven by minimum volatility, single and multifactor funds, according to BlackRock.

Smart beta refers to alternative index construction, a move away from traditional indices which weight their constituents by their size in the market. A smart beta index might be compiled with a tilt towards smaller companies (which tend to outperform in the long run); ‘cheap’ stocks which are trading below their true value based on earnings; those which have momentum; or those which tend to be less volatile; among a range of other ways to assemble an index.

But the proliferation of smart beta investment products means more and more investors are pouring capital into these indices and their constituents. This process, for example, will prop up the prices of an index of cheap stocks, thereby nullifying the strategy over the long term (or as such a strategy reaches peak popularity). A growing amount of equity capital chasing these products will mean smart beta products will begin to resemble market cap-weighted indices.

In the near term, smart beta products can be rebalanced by reducing the weighting of stocks which have gained the most in a portfolio, and adding to those which have been left behind. By theory, however, all market inefficiencies would have been exploited over the long term. Rebalancing also incurs transaction costs, while the index’s market cap-weighted benchmark will not be subject to these extra fees.

Some market commentators have already blamed corrections in various financial markets on strategies which exploit inefficiencies, including hedge funds and smart beta products.

Furthermore, while smart beta’s rise was partly based on its simplicity, many new products are becoming complex since they use a multi-factor approach so as to avoid cyclical periods of underperformance.

Despite these theoretical arguments against smart beta’s long-term sustainability, the strategy has broadly become accepted as an alternative risk driver and important component in a diverse investment portfolio. Its ability to single out market abnormalities provides a handy tool for investors to beat the market.

Considering that traditional market capitalization-weighted indices became popular decades ago because they offered a solution to the liquidity constraints of the time, there should be little reason that size-based indices remain the sole focus of portfolio managers since these constraints no longer apply. Smart beta, sometimes referred to as custom indexing, offers an attractive alternative to usual benchmarks and these products will likely have increasingly big roles to play in investor portfolios.

In the face of some skepticism about their long run potential, many smart beta and risk premia strategies have generated positive risk-adjusted returns and beaten the market on key metrics over the long run. Index provider MSCI conducted a study over a 23 year horizon which suggested these strategy types outperformed the market over that investment period. Smart beta and risk premia are factor-based alpha strategies, which are becoming popular worldwide.

There are also a growing number of strategies under the smart beta umbrella, allowing investors to better align their portfolios with their preferences, or risk-reward profile. Smart beta strategies can complement traditional indices, while also adhering to the benefits which helped make smart beta so popular – including transparency, diversification and lower fee structures than actively-managed funds.

Smart beta and other quantitative strategies (those which aim to deliver higher returns than the overall market) can also be used both to target higher returns and manage risks.