Smart beta: Is factor investing delivering on its promises?

Cost and efficiency are central tenets to most investment offerings. 

The idea that smart beta can be the best of both worlds – providing active market exposure through lower and more transparent passive-style costing – is a popular simplification of the benefits of these strategies.

But is this accurate and should we expect to see greater migration as smart beta strategies proliferate?

Traditionally, investment returns have been categorised as alpha or beta, and the corresponding strategies have been designed primarily around asset allocation.

Smart beta goes beyond this methodology and incorporates a greater degree of granularity when selecting investments.

Sophisticated smart beta

Since being popularised in the 1990s, smart beta strategies have become more diverse.

The original strategies identified the value-based factors driving returns, but today managers use more sophisticated and subjective screens.

Many smart beta strategies are based on the assumption that investment returns can be attributed to a significantly greater number of varying systematic factors.

The twin objective is to enable investors to achieve a better risk-return profile compared with the static beta of traditional index funds, at comparable cost, while gaining access to alpha.

From a passive strategy perspective, investors can now benefit from exposure to dynamic market factors but with the cost and transparency normally associated with static or beta market exposure. 

Quantitative analysis and the rise of active share has highlighted the number of active managers who hold a benchmark index and/or where their returns are driven by factors that can be readily identified and commoditised in a systematic approach.

From a cost and implementation perspective, utilising a more systematic methodology makes perfect sense.

Limitations

Smart beta strategies do have limitations – most products available today are long-only, which makes it harder to allocate using specific factor themes compared with traditional asset allocation.

Capturing most dynamic factors requires long and short positions to efficiently gain exposure. So the absence of short positions, reduces the ability to capture true factor returns.

Similarly, smart beta investors must accept the leverage constraints which encumber long-only products.

Smart beta was born out of the recognition that some active returns may emanate from systematic factors which could be replicated in a disciplined and transparent model. This brings its own problems.

Being rules-based means opportunist investors can front-run a smart beta strategy, profiting from the predictable nature of an underlying strategy’s rebalancing. The more successful the strategy, the more likely someone will exploit its rebalancing rules.

A more subtle limitation is in relation to smart beta’s use from a passive perspective.

Traditional market cap-weighted indices are useful as benchmarks and for illustrating opportunity cost. In simplistic terms, they are a true representation of investor sentiment.

Theoretically, the sum of all holdings will equate to the value of the index. Conversely, this is not the case for smart beta because weightings are relative to the size of a company.

In other words, for one investor to have a holding in a stock that is greater than its weight based on market cap, another investor has to be willing to have a holding in that same stock that is less than its cap-based weight.

So we cannot all hold the same smart beta portfolio.

If multiple funds attempt to capture some dynamic factor exposure there is the possibility that rebalancing will have a large systematic impact on the returns for a particular factor, for example in the quant crisis of 2007.

Here to stay

Given the current size of the smart beta market, this is highly unlikely in the foreseeable future.

Despite these limitations, smart beta is here to stay.

The drive and appetite to harvest sources of return in a cost-effective manner will push investors to look beyond the current status quo to a combination of strategies incorporating smart beta.

Granted not all smart beta strategies will deliver, but as a method of dissecting drivers of return, a systematic approach is difficult to ignore in a more sophisticated and transparent world.  

James d’Ath is director at Indexx Markets