Smart Beta attracts increased attention
With the debate around the merits of active versus passive approaches to asset allocation continuing to rage, smart beta – an investment strategy that encompasses aspects of both these approaches in a cost-effective manner – is attracting increased attention among both global and local investment strategies.
If correctly used, this strategy has the ability to unite supporters of both the passive and active camps. “Smart beta strategies have grown in popularity across the investment industry in recent years; yet smart beta is a broad term and the lack of universal definition has led to confusion among some investors.
Levitan says smart beta is a rules-based strategy that deviates from the traditional market capitalisation indices. In this way, the connection between a security’s price and its weight in a portfolio is broken. This is in contrast to existing investment approaches that track or attempt to outperform a market index, which is constructed based on security market capitalisation. “In essence, an equity smart beta strategy identifies the key factors that drive the outperformance of equities and uses them in portfolio construction.”
“There are a number of sources of equity returns or characteristics that drive performance. Smart beta is concerned with identifying and selecting those characteristics that best compensate an investor for taking on risk.”
He says the motivation for deviating from an established index (like the All-Share or the Shareholder weighted Index (SWIX) is to improve the chances of outperforming the benchmark by having greater exposure to those securities with higher expected returns, a strategy that requires strong empirical research and a good rationale.
Levitan notes that academic research has provided insight into why and how particular stocks outperform over time, taking into account factors such as the size and value; the momentum of the stock; and the profitability. “There are many criteria one can choose from but common characteristics should include a persistent performance across time periods, pervasive across markets and be robust to alternative specifications.”
Clearing up the confusion
However, he says there are already some misconceptions around the concept. “Smart beta has started to be used broadly to encapsulate a wide range of strategies that fall in-between an active or passive strategy, which is not an accurate representation of the approach. Unfortunately, this has created much confusion amongst investors as to what it is and whether it truly delivers value.”
Levitan notes that there are a number of pitfalls when choosing the right smart beta solution. “Not all smart beta strategies are created equal. For example, we believe that smart beta strategies that do not consider a security’s price are flawed. Valuation models and intuition suggest that expected returns depend on the profits. As a result, investors cannot ignore the share price; it may seem fundamental but the price of a share is hugely important.”
Furthermore, he notes that while data reported in financial statements is useful to assess expected returns, in reality these changes are infrequent; whereas in a well-functioning market, prices will reflect constantly updated expectations as it contains real-time information about both company and market-wide events.”