Smart Beta: What’s the fuss about?

The debate between whether passive index trackers are better than actively managed unit trusts has never really gone away. Now there is another buzzword in the mix, smart beta, which promises a solution that combines the best of passive and active investing.

The problem with jargon and this term in particular, is there is no concise definition and therefore the term has become abused. Advocates suggest that “smart-beta” is a brilliant advance in investment strategy, while detractors suggest that it is just a fabulous marketing term.

To unpack the term one needs to go back to basics. What is the ‘beta’ of an investment?
Simply, ‘beta’ is the volatility of a portfolio relative to that of the market as a whole.

In this case the market could be the All Share index or S&P 500. The market has a ‘beta’ of 1. If your portfolio has a higher or lower ‘beta’, it is more or less volatile than the market.

If you employ an active fund manager who gives you a return that is different from that of the market (either positive or negative), this under- or outperformance of the market is called ‘alpha’.

Pure beta ETFs (such as the Satrix 40) put the market at the centre of the universe whereby each stocks weight in the portfolio is in proportion to its market capitalisation.

The debate between whether passive index trackers are better than actively managed unit trusts has never really gone away. Now there is another buzzword in the mix, smart beta, which promises a solution that combines the best of passive and active investing.

The problem with jargon and this term in particular, is there is no concise definition and therefore the term has become abused. Advocates suggest that “smart-beta” is a brilliant advance in investment strategy, while detractors suggest that it is just a fabulous marketing term.

To unpack the term one needs to go back to basics. What is the ‘beta’ of an investment? Simply, ‘beta’ is the volatility of a portfolio relative to that of the market as a whole.

In this case the market could be the All Share index or S&P 500. The market has a ‘beta’ of 1. If your portfolio has a higher or lower ‘beta’, it is more or less volatile than the market.

If you employ an active fund manager who gives you a return that is different from that of the market (either positive or negative), this under- or outperformance of the market is called ‘alpha’.

Pure beta ETFs (such as the Satrix 40) put the market at the centre of the universe whereby each stocks weight in the portfolio is in proportion to its market capitalisation.

A smart beta approach to investment recognises that stocks have differences in expected returns. Smart beta is a methodology for choosing those stocks with better expected risk-adjusted returns. Thus it breaks the link between a stock’s price and its market capitalisation when deciding on its weight within the portfolio.

“Smart” refers to the use of an alternative methodology rather than following an index’s size-based (market-cap) allocations. And systematic suggests the strategy is largely rules-based and does not require fundamental stock analysis. Thus a smart beta investment strategy is designed to add value by strategically choosing, weighting and rebalancing the companies built into an index based on objective factors.

There are multiple sources of equity return (premia). “Over the years, research has shown that stocks exhibiting certain characteristics are expected to generate better returns over time,” says Shaun Levitan, executive director of investment manager Colourfield. Perhaps the best known of this research is that of Fama and French (1992), which identified size (smaller cap stocks perform better over time) and value (buying stocks with a low price relative to their NAV) as better indicators of future performance than other characteristics.

Another source of return or premia is based on a company’s profitability, he says. He believes momentum (high returns over 3-12 months) can be implemented as part of the trading strategy but adds that this shouldn’t form part of the core portfolio construction process (although many offerings do just that).

These factors seem to support the bias towards active strategies. However Levitan points out that Fama and French have done research (2010) which suggests that 3% of active managers deliver sufficient alpha to cover their fees when the benchmark has been adjusted for these characteristics and not simply a market-capitalisation index. “Much of the historic outperformance achieved by active managers can be explained by having higher exposure towards proven factors such as those mentioned above”.

Thus by combining smart beta offerings in a portfolio, investors can benefit from the advantages of passive investing, such as transparency, lower costs and the removal of the risk of underperforming active managers, but also provides the potential for outperformance over traditional index trackers.

So what is the conclusion? Is smart beta a brilliant advance in investment strategy or a fabulous marketing term?

It would appear that it is closer to the former and South Africa now has dozens of ‘smart’ ETFs in the market, including Satrix’s RAFI fund, Absa Momentum Equity ETF and the S&P GIVI50 ETF.

However Levitan cautions that some smart beta strategies have pitfalls that investors should be aware of. Not all applications of a systematic approach to investing are created equal. He says that examining several approaches through the lens of decades-old research into empirical pricing show that some smart beta strategies may offer little more than exposure to the well-documented market, size and value premia, with exposure achieved indirectly and in varying degrees.

The debate between whether passive index trackers are better than actively managed unit trusts has never really gone away. Now there is another buzzword in the mix, smart beta, which promises a solution that combines the best of passive and active investing.

The problem with jargon and this term in particular, is there is no concise definition and therefore the term has become abused. Advocates suggestthat “smart-beta” is a brilliant advance in investment strategy, while detractors suggest that it is just a fabulous marketing term.

To unpack the term one needs to go back to basics. What is the ‘beta’ of an investment? Simply, ‘beta’ is the volatility of a portfolio relative to that of the market as a whole.

In this case the market could be the All Share index or S&P 500. The market has a ‘beta’ of 1. If your portfolio has a higher or lower ‘beta’, it is more or less volatile than the market.

If you employ an active fund manager who gives you a return that is different from that of the market (either positive or negative), this under- or outperformance of the market is called ‘alpha’.

Pure beta ETFs (such as the Satrix 40) put the market at the centre of the universe whereby each stocks weight in the portfolio is in proportion to its market capitalisation.

A smart beta approach to investment recognises that stocks have differences in expected returns. Smart beta is a methodology for choosing those stocks with better expected risk-adjusted returns. Thus it breaks the link between a stock’s price and its market capitalisation when deciding on its weight within the portfolio.

“Smart” refers to the use of an alternative methodology rather than following an index’s size-based (market-cap) allocations. And systematic suggests the strategy is largely rules-based and does not require fundamental stock analysis. Thus a smart beta investment strategy is designed to add value by strategically choosing, weighting and rebalancing the companies built into an index based on objective factors.

There are multiple sources of equity return (premia). “Over the years, research has shown that stocks exhibiting certain characteristics are expected to generate better returns over time,” says Shaun Levitan, executive director of investment manager Colourfield. Perhaps the best known of this research is that of Fama and French (1992), which identified size (smaller cap stocks perform better over time) and value (buying stocks with a low price relative to their NAV) as better indicators of future performance than other characteristics.

Another source of return or premia is based on a company’s profitability, he says. He believes momentum (high returns over 3-12 months) can be implemented as part of the trading strategy but adds that this shouldn’t form part of the core portfolio construction process (although many offerings do just that).

These factors seem to support the bias towards active strategies. However Levitan points out that Fama and French have done research (2010) which suggests that 3% of active managers deliver sufficient alpha to cover their fees when the benchmark has been adjusted for these characteristics and not simply a market-capitalisation index. “Much of the historic outperformance achieved by active managers can be explained by having higher exposure towards proven factors such as those mentioned above”.

For example, an equally weighted Top 40 equity offering is aiming to earn investors the size premium by reducing exposure to the larger stocks and up-weighting smaller ones. There are more efficient ways of achieving this, he says. The trading costs incurred in implementing this strategy alone are likely to erode the additional expected return.

He also has concerns about a fundamental weighting strategy, which is essentially a value strategy. However, it has the disadvantage of ignoring a security’s price. Fundamental data can become stale. By ignoring price, relevant and important information contained in price is also ignored. It is counter-intuitive to build a strategy targeting higher expected returns without taking into account the prices paid for those securities.

He says that with smart beta “as with any other investment approach, it is important to understand the objectives of these strategies, drivers of their returns, and crucially, their implementation.”