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 concept of manager risk is seldom considered when talking about passive indexing, or investment strategies that track a market-weighted index. However, it is of primary importance when considering smart beta indices. Indeed, passive implementation based on smart beta indices from well-known providers can still be exposed to the same manager risk as active strategies. In this case the index provider or a third party partner defines the strategy and builds the methodology. This is not dissimilar to quantitative managers who actively define, build and manage portfolios (which are in essence proprietary indices), with the important distinction that active managers have the potential to benefit from the flexibility of leeway in implementation and trading. Therefore, it is important to evaluate and understand the hidden risks of following a passively implemented smart beta index.

When is a factor strategy1 a factor strategy?
Passive smart beta strategies can typically offer investors lower fees while still providing exposure to common risk factors. However, due to their passive nature, smart beta indices tend to exhibit significant constraints. It is typical for providers to apply diversification constraints at the sector, country and position levels which can force these strategies to hold sub-optimal allocations. In fact, many providers apply these constraints relative to a market cap weighted index which can yield portfolios that are overweight to unwanted market segments. It is therefore typical for such indices to feature an erosion of the factor they seek to exploit as the final index will tend to have high correlation to its cap-weighted parent. These products can typically be thought of as tilted towards a factor rather than a true factor strategy.

Why rebalancing frequency matters
Index providers have an incentive to prioritize cost over investment outcomes. By following an index with a quarterly or semi-annual rebalancing frequency, investors can expose themselves to a portfolio that, in between rebalances, may no longer reflect the factor and outcome it had initially sought.

A strong focus on low costs can be reflected throughout the supply chain – from the early development (which typically yields similarity to the parent index), to implementation – where a premium can be placed on low turnover and less frequent rebalancing aimed at lowering overall transaction costs. Such constraints can have unintended effects on smart beta indices. Unlike traditional indices based on market segments such as market-cap, geography, and sectors, securities that display the characteristics of a given smart beta factor – such as company size, value, and volatility – tend to incur more change over time. Whereas a securities’ market-cap, geography or sector classification is relatively static, it’s exposure to a given factor is prone to change more frequently. As a result, some passive2 indexing investment strategies may not be in line with their stated outcome at a given time.

Avoiding “path dependency”
An additional effect of a low turnover constraints and a sparse rebalancing schedule is the concept of path dependency. Put another way, if a given portfolio can only turn over within rigid constraints, the manager might never be able to truly shift the allocation to an optimal basket of securities in their effort to fulfill their stated investment objective. Take for example the case of a low volatility3 portfolio with semi-annual rebalancing and a maximum allowable rebalancing turnover of 30% per annum. In an evolving market where the profile of those securities that makeup the current portfolio has shifted from low volatility to high volatility, the portfolio will only be able to trade (turn-over) about a third of the portfolio every year. The portfolio then runs the risk of constantly playing catch-up while attempting to remove the unwanted exposure ultimately yielding a sub-optimal expression of the low volatility factor.

It is important to understand that index providers typically privilege lower overall implementation cost over a given investment outcome. Although this can lead to low fees, it can also lead to unwanted investment outcomes which have the potential to introduce a significant amount of risk and uncertainty into a portfolio. While actively managed smart beta approaches also involve risks and often charge investors a higher price point, they can help resolve these issues through a higher frequency of rebalancing and daily portfolio monitoring. Moreover, unlike passive investments, active investments do not track or replicate an index. Thus, the ability of the investment to achieve its objectives will depend on the effectiveness of the portfolio manager.4
1 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.

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 The term low volatility refers to limited fluctuation of value over time. By contrast, high volatility refers to dramatic fluctuation of value over time.

4 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.

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

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.

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

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