Smart beta: Understand the impact on your wider portfolio

Smart beta strategies, sometimes known as 'cheap alpha', are essentially systematic approaches to selecting and trading stocks and bonds beyond simple passive cap-weighted benchmarks.

The complexity of this investment discipline means that investors must take time to carefully scrutinise the potential merits and drawbacks before taking the plunge

They systematically trade towards assets that exhibit certain investment characteristics that have methodically delivered distinct premiums – by either adding additional returns or by reducing downside risk.

As a simple example, a value based smart beta strategy would consistently buy those stocks that either have high book or current earnings value to current market price, in other words buying cheap and selling expensive.

Significant historical data suggests that, over time, a simple systematic trading strategy following this approach would, after all costs, outperform a market cap-weighted passive benchmark. The existence of this additional return is rationally argued as essentially a risk premium – based on a behavioural bias for investors to over-sell stocks in times of stress.

There is now a long list of so-called smart beta strategies. These include momentum/trend, quality, carry, activist, size, return on capital, deep value, current value, capital usage, risk, climate, low volatility, fallen angels and merger arbitrage. The list is far from exhaustive.

New tools, new problems

With this in mind, pension scheme asset allocators, be they asset managers, trustees or advisers, now face a number of new headaches.

First, which factors should they believe in? Trustees should take a somewhat cynical approach to validating any factor. Does the historical data-based back-test demonstrate with statistical relevance the existence of the factor? Have all transaction costs, which can be significant for some frequent trading strategies, been taken account for in the back-test?

Trustees should consider whether there is a fundamental rationale for the existence of premium from the strategy. What is the market capacity for the strategy? Over what time period is the strategy likely to deliver its expected excess return? Trustees must also think about how the strategy interacts with other observed strategies, and how consistently it should deliver its excess return premium.

Consider how smart beta fits in with your strategy

Second, investors need to think about how they allocate to these strategies. It is important to have a good understanding of how these factors interact with each other and the rest of the scheme’s portfolio. Trustees need to decide whether a different portfolio of these strategies should be built to meet the scheme’s needs over different time periods.

How should we tilt our allocations to these strategies based on our long-term strategic market outlook? How should we tilt our allocations to these factors based on our short-term dynamic market outlook? Do we need to integrate risk management when combining these strategies to guard against unintended risk build-up?

Finally, how can performance of these strategies be measured effectively through time? Clearly, any systematic approach that is well implemented should deliver performance in line with an underlying index that has been crafted to replicate that strategy.

However, it cannot be considered good governance to measure the strategy’s effectiveness by simply tracking the index. Instead, the best option is the simple good governance rule of establishing a transparent and objective benchmark that is constructed independently from those responsible for the strategy design.

Smart beta is by no means niche, but the complexity of this investment discipline means that investors must take time to carefully scrutinise the potential merits and drawbacks before taking the plunge.

While they can provide a great opportunity for pension schemes to access cheap risk-adjusted returns, schemes should not underestimate the governance costs. Some savings can be made by transferring investment decision-making from asset managers to trustees. This will need to ensure that trustees have the appropriate skills and governance processes in place to undertake the task.

David Hutchins is portfolio manager, multi-asset Solutions EMEA, at AllianceBernstein