Smart beta is often brought up as one of the most confusing investment terms in the market. 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 series, we’ll 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.

The most common misconception I hear in regard to smart beta1 investing strategies is that all smart beta approaches are equivalent. In fact, many individual investors and financial professionals assume that all factor strategies2 are created equal – likening various factor-based investment strategies to the cap-weighted index world, where index components are weighted according to the total market value of their outstanding shares.

However, as I’ve discussed previously, traditional (market-cap weighted) indices can exhibit low tracking error3 and high correlation to each other. This is due mainly to the fact that their weighting scheme is based on a well-established objective measure and very little leeway exists in defining and implementing these indices. On the other end, there are no objective measures and definitions for most smart beta strategies, which in turn tend to exhibit characteristics more akin to actively managed4 strategies, as each provider is free to make choices that define their own investment approach.

Low Volatility Smart Beta: Sorting Out the Available Options
Take low volatility for example, one of the most followed smart beta strategies. Low volatility investment strategies, sometimes referred to as managed volatility or minimum variance strategies, attempt to deliver equity market returns with less return variability than an index. A variety of players have developed products that seek to take advantage of the low volatility anomaly inherent to global equity markets. However, each provider has a different definition of volatility, and which metrics they use to define the factor. Standard deviation is often the metric of choice – but approaches can vary in terms of the past period being evaluated, ranging anywhere from 3 months to much longer periods (e.g. 5 years).

In addition, some low volatility approaches incorporate correlations – a statistical measure of how two securities move in relation to each other – while others follow a simpler approach. What’s more, implementation can also vary widely. Some strategies choose to focus on the lowest volatility securities in the universe, adopting a simplistic weighting scheme (i.e. equal weight5), while others use complex optimization techniques to enhance diversification or isolate unintended exposures.

Finally, the majority of low volatility approaches fall into the traditional indexed approach and seek to tilt a headline index towards the low volatility factor, while focusing implementation on minimizing turnover and trading cost. Some asset managers have introduced strategies that take an active implementation approach, building risk-focused strategies from the ground up and focusing implementation on the investment outcome (i.e. seeking to deliver capital appreciation while reducing volatility).

Choosing Smart Beta – Wisely
Given that all low volatility strategies are not created equal, the decision to choose one approach versus another is of primary importance when considering the range of available smart beta strategies. Indeed, unlike in the cap-weighted space, going passive does not take manager risk away in the world of smart beta, as the index providers’ definition and methodology is in essence an active choice.

It follows that unlike traditional index strategies (which can be viewed as commoditized), cost may no longer be the sole primary concern when purchasing a smart beta product. Evaluating individual strategies, understanding their benefits and drawbacks, and getting a clear picture of their actual investment outcome are fundamentally important.

The case for educated investment decision-making

A good analogy may be to compare traditional indexing with gasoline – gas is gas – and while finding the lowest price gas for one’s car is pragmatic, it’s not necessarily essential. On the other end, when selecting a smart beta low volatility investment strategy, investors and financial professionals could benefit from taking an approach similar to shopping for a new automobile. They can seek to understand the benefits and drawbacks, features, and characteristics of each investment vehicle before making a decision, because investment vehicles and automobiles both have features which may not be substitutable and they should be sure they are gaining access to the features that are most important to them.
1 The term “smart beta” is used to describe investment strategies that emphasize capturing investment factors or market inefficiencies in a rules-based and transparent way.
2 Factor investing is an investing strategy in which securities are chosen based on attributes that are associated with potentially higher returns.
3 The term tracking error, sometimes called active risk, refers to the difference between a portfolio’s returns and the benchmark or index it was meant to mimic or beat.
4 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.
5 Equal weight is a type of weighting that gives the same importance to each stock in a portfolio or index fund.

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Diversification does not guarantee a profit or protect against a loss.

All investing involves risk, including the risk of loss. It is not possible to invest directly in an index. Alterative investments involve unique risks that may be different from those associated with traditional investments, including illiquidity and the potential for amplified losses or gains. Investors should fully understand the risks associated with any investment prior to investing.

Volatility management techniques may result in periods of loss and underperformance, may limit the Fund's ability to participate in rising markets and may increase transaction costs. Unlike passive investments, there are no indexes that an active investment attempts to track or replicate. Thus, the ability of an active investment to achieve its objectives will depend on the effectiveness of the investment manager.​

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.