Smart Beta Strategies

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Smart beta strategies use alternatively-constructed indices to take advantage of market inefficiencies and underlying risk factors. Factor-driven approaches have become so popular that even theory-based pricing models now take factors into account when evaluating investments.Standard benchmark indices weight their constituents by market capitalization, or size, and can act as a proxy for broad market exposure. Popular equity benchmarks for US investments include the S&P 500 Index and Russell 2000, among others.

The larger a stock, the more important it is in the index – meaning that the rises and falls of a big stock will affect the overall index more than the changes of a smaller stock.

While many fund managers value these indices since they offer a cheap way to gain broad market exposure, these indices have inefficiencies partly because the market does not always accurately price securities. For example, size-weighted benchmark indices can become heavily tilted towards sectors or towards stocks that have become expensive.

Smart beta strategies aim to take advantage of these inefficiencies and market abnormalities by using alternative index construction methods that follow predetermined stock-selection rules.

Some smart beta funds track the same stocks as traditional benchmark indices, but offer different exposures, or weightings, to underlying stocks. Alternatively, some smart beta funds do not replicate the holdings of benchmarks but follow predetermined rules in order to select stocks.

A smart beta strategy might use the same constituents as the S&P 500, but assign alternative weightings to each stock in an effort to boost risk-adjusted returns.

While this index will likely target improved returns and lower volatility, it will be highly correlated to the benchmark, meaning that when equity markets decline, so will the smart beta index.

While long-only smart beta funds target idiosyncratic risks, they still have beta, or macro, exposure. This differs from long-short risk premia strategies, which also target underlying factors but which can generate absolute returns in all market conditions through long-short trades.

Another smart beta strategy, meanwhile, might be made up of low-volatility stocks or stocks which pay high dividends.

Smart beta funds are measured against benchmark indices, with the aim of yielding a few percentage points worth of extra return or reduced volatility risk. Strategy returns are measured on a risk-adjusted basis.

Smart beta indices are effectively a combination of active and passive investing, allowing for market-beating returns with lower costs than mutual funds. Smart beta funds, sometimes called custom indices, cost slightly more than traditional size-based ETFs, but far less than mutual funds.

For that reason, many investors now see them as attractive complements to, or substitutes for, long-only mutual funds. Part of the attraction of smart beta funds lies in the fact that they are designed to be transparent, following a set of rules in the stock-selection process.

The growth of rules-based and transparent smart beta investing comes on the surge in popularity of passive index investing, as assets under management flourish. BlackRock, which is the largest manager of exchange-traded funds (ETFs), predicts that global smart beta ETF assets will balloon from $282bn in May 2016 to $1 trillion by 2020 and $2.4 trillion by 2025.

The growth mirrors the increasing appetite for portfolio risk management and diversification by underlying factors rather than by asset class or sector.

Smart beta indices are often available as ETFs, making them accessible to most investors, including individual retail investors. Institutional clients however have more options at their disposal, having access to more sophisticated smart beta products.

Smart beta strategies use factor-based investing techniques to identify underlying risk factors that can be exploited. Factors such as size, momentum and value explain why some stocks outperform others.

Value smart beta funds provide a tilt towards stocks which the market has undervalued. Small-cap indices target small stocks since these tend to outperform over the long term. Momentum strategies target stocks with upward momentum. Volatility strategies, meanwhile, strive for risk management by targeting low-volatility stocks.

Many smart beta funds, because of their underlying factors, are not highly correlated to one another. This means that they tend to perform at different times of the market cycle, and so by combining two or more strategies in an overall portfolio, investors can smooth returns and gain access to better risk management.

In some ways, smart beta investing seems to break financial theory rules and assumptions. Modern portfolio theory, which is based on the assumption of efficient financial markets, suggests that greater returns come from accepting greater investment risk. However, this is not always the case and some factors offer better returns because of inefficient pricing by the market.

Smart beta funds can invest in a range of asset classes, but usually target equity markets and sometimes commodities. Until recently, fixed income was not often targeted by smart beta index providers since bonds are difficult to include in rules-based indices. However, this has begun to change and there are now a wide range of fixed-income products available.

While equity-focused smart beta indices are measured against market-cap-weighted benchmarks, fixed-income products are measured against liability-weighted benchmarks.

There has already been some consolidation in the smart beta industry, with large asset managers buying into index providers in an effort to build up their smart beta units.