Smart beta1 is often brought up as one of the more confusing terms in the investing space. Generally speaking, smart beta strategies seek to provide a more cost-effective option for delivering portfolio performance, diversification, and risk management through the use of alternative index construction rules.

However, not all smart beta strategies are built the same. In this article, we take a new look at smart beta strategies with an eye towards contrasting indexed-smart beta and the next generation of actively-implemented smart beta.

Smart beta is often viewed through a passive2 investment lens and applied to style or factor investing.3 Yet similar strategies that pre-date the coining of the term “smart beta” were often implemented in an active fashion. Examples of such strategies date back to the first half of the 1900s, when value factor investing was popularized.4 Factor investing evolutions continued the 1960s and 1970s.

Tech Factor
What’s really new about today’s smart beta strategies is the technological revolution behind them: easier data access and advanced computer capabilities bring enhanced discipline to investment processes, as well as a wider scope of potential applications. The advance of smart beta indexing has helped popularize quantitative factor investing5 by making it more accessible to investors. But the process of indexation6 has also led in some cases to the introduction of various risks which have the potential to erode the value investors can derive from such strategies.

What is Indexation?
At its core, the primary goal of indexation is to provide the most cost effective exposure to a market segment. This approach has proven adequate for providing market exposure in the traditional sense using market-capitalization7 or price-weighted8 approaches as these measures are objective and widely accepted. However, passive smart beta strategies vary widely in definition, approach and implementation, which in turn leads to a wide variation in resulting portfolios and outcomes. In addition, risk factors may not benefit from the stability of a market-capitalization, country, or sector classification. This can create a need to rebalance when the market structure changes and might not fit well within a bi-annual, turnover constrained passive framework. Finally, in order to attempt to exploit a market anomaly or risk factor, a strategy needs to be thoughtfully constrained in a manner that does not erode its value.

The Quest for Smarter Beta
Some investment companies have developed actively implemented quantitative strategies that seek to overcome the hurdles of purely passive smart beta in the attempt to provide a purer exposure to factors such as volatility. While fully embracing the benefits of discipline and breadth brought by a systematic approach, these solutions can introduce portfolio manager oversight where the investment team believes it can add value: active oversight and implementation.

Understanding Active Factor Investing
Going active with factors can take different forms from a more traditional fundamental strategy to a quantitative approach. Although each approach has its potential advantages and disadvantages, investors may benefit from the full attention of portfolio managers who are providing consistent monitoring of the portfolio in an attempt to see a strategy and take advantage of the given factor/anomaly as effectively as possible. Unlike passive implementations, these strategies have the potential to quickly react to evolving market conditions and shift the burden back to the manager in an attempt to keep the portfolio representative of the stated investment objective. This constant monitoring and when needed re-adjusting of the portfolio can yield higher turnover and transaction expenses and is at the heart of active implementation: seeking the right tradeoff between implementation cost and investment outcome.

The Importance of Due Diligence
Overall, the key is to consider that any strategy you are considering for your portfolio follows a sound investment thesis, robust investment process, and the potential to provide consistent investment outcomes in line with the stated objective. As we have seen in this series, passive smart beta does not take manager risk away. Whether passive or active, robust investment due diligence remains important and should at least include the 3 Ps: People, Philosophy and Process.

Every investment approach has potential benefits and drawbacks. The decision to follow a smart beta approach means an investor may be exposed to manager risk. But the outcome-oriented characteristic of smart beta can make these strategies considerable as part of a well-diversified portfolio.
to factors such as volatility [KB1] .

 [KB1] Added hyperlink to MVIN informational webpage

1 Smart beta refers to an investment style where the manager passively follows an index designed to take advantage of perceived systematic biases or inefficiencies in the market. Smart beta strategies involve risk, including risk of loss.

2 Passive management (also called passive investing) is an investing strategy that tracks a market-weighted index or portfolio. By contrast, active management (also called active investing) refers to a portfolio management strategy where the manager makes specific investments with the goal of outperforming an investment benchmark index.

3 Factor investing is an investing strategy in which securities are chose based on attributes that have the potential to generate return. Common factors reviewed in factor investing include style, size, and risk.

4 A value factor is any characteristic that can help explain the risk and return of a group of securities.

5 A quantitative factor is an investment outcome or potential investment outcome that is measurable in numbers or numeric term. This could include costs, revenues, or non-financial data for outcomes to a decision.

6 Indexation refers to the linking of adjustments made to the value of a security to a predetermined index.

7 Market capitalization refers to the outstanding value of a company’s shares

8 A price-weighted index is an index in which each stock influences the index in proportion to its price per share. Its value is generated by adding the prices of each of the stocks in the index together and dividing them by the total number of stocks.

Indexes are not investments, do not incur fees and expenses and are not professionally managed. It is not possible to invest directly in an index.

Unlike passively managed investments, there are no indexes that an active investment attempts to track or replicate. Thus, the ability of the investment to achieve its objectives will depend on the effectiveness of the portfolio manager. There is no assurance that the investment process will consistently lead to successful investing.

Investing involves risk, including the risk of loss. Investment risk exists with equity, fixed-income, and alternative investments. There is no assurance that any investment will meet its performance objectives or that losses will be avoided.

CFA® and Chartered Financial Analyst® are registered trademarks owned by the CFA Institute.

Diversification does not eliminate the risk of experiencing investment losses.

This material is provided for informational purposes only and should not be construed as investment advice. The views and opinions expressed above may change based on market and other conditions. There can be no assurance that developments will transpire as forecasted.


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