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Alpha, Beta and Smart Beta
In recent years smart beta strategies have seen increasing investor demand, thanks to their combined offering of benefits from passive and active investing. Smart beta strategies aim to give investors the opportunity to potentially achieve higher returns than the traditional market-capitalisation indices, while at the same time lowering costs.
We take a closer look at how they do this.
What is Beta?
Beta is a measurement of the market relative risk of an individual stock. It describes a stock’s sensitivity to the movement of the broader stock market. For example, let’s say the beta of a broad stock index is expressed as 1.0. A stock with a beta of 1.0 suggests that it moves in line with the index. But if the stock has a beta of 1.2, this suggests it will move more than the market. Another way to think about this is volatility. A stock with a beta greater than 1 will move more than the market – up or down – is more volatile than the market, while a stock with a beta less than 1 will move less than the market and is said to be less volatile than the overall market.
What is Alpha?
Alpha is a term often used in conjunction with beta. While beta looks at the market risk, alpha focuses on characteristics that drive the performance. Specifically, it is a measurement of a strategy or a portfolio manager’s ability to outperform an index. Alpha is the result of active investing, and the higher the excess return the strategy generates, the higher the alpha.
How do alpha and beta relate to smart beta? Smart beta strategies are systematic active investment strategies, their goal is to deliver beta and while in addition generating alpha.
Smart Beta Explained
Smart beta – also called strategic beta or factor investing and a few other related terms – generally refers to rules-based approaches to investing. These strategies seek to capture specific factors such as value or quality as well as others, that active managers have commonly sought exposure to. Smart beta strategies do this while preserving the benefits of traditional indexed investments such as discipline, transparency, consistency and low cost.
Generating Alpha with Smart Beta
Smart beta strategies seek to capture specific performance factors to deliver an excess return over an index – similar to an active investment strategy. Smart beta strategies also aim to improve diversification and reduce risk. Investors can access single or multi factor investment strategies investing through vehicles such as an ETFs.
Five Common Smart Beta Factors
1. Value
Value stocks are those that trade at a low price relative to their fundamentals, such as earnings or sales. They have been shown to outperform the broader market indices over the long term1, potentially due to investors’ behavioural biases and the reward for taking additional risk/providing liquidity in a stressed environment.
2. Quality
This factor focuses on companies with low debt, stable earnings and high profitability. Higher quality companies seem to be rewarded with higher returns over the longer term because they have been shown to be better at deploying capital and generating wealth than the broader market. This is particularly true in times of market stress when a company’s ability to service debt and provide visibility on earnings become more important.
3. Size
Small capitalisation stocks have tended to outperform their large capitalisation peers over time.2 There are a number of potential drivers for the long term outperformance of smaller capitalisation stocks. Their smaller size may mean they are generally considered to be riskier – for instance they are generally less diversified companies, less covered by analysts and less well known. This may have a number of implications – investing in small capitalisation stocks more than ever requires a well diversified portfolio to reduce stock specific risk; and furthermore the market may demand a higher expected rate of return for holding these stocks – the so-called “small capitalisation premium”.
4. Low Volatility
The long term historic outperformance of low volatility strategies may be explained by the theory that some investors overlook “boring” low volatility stocks in favour of “glamorous” ones and, in the process, miss out on the consistent returns low volatility stocks can offer. The implication of this is that the risk/return relationship holds between asset classes, but not necessarily within an asset class.
5. Momentum
Empirical evidence shows that stocks that have done well recently have greater potential of doing well in the near term than the broader market, and stocks that have performed poorly continue to perform poorly.3 Portfolios which consider momentum can benefit from the momentum in securities over the shorter term.
Different firms recognise slightly different factor lists, but the factors above are the most rigorously tested and debated over the long term.
The Move to Multi-Factor Investing
One challenge presented by single factor investing is that factors are difficult to time over short time periods. Single factors are cyclical and are prone to extended periods of out/underperformance based on changes in the business cycle and the market environment.
By combining factors with different attributes that behave differently throughout the business cycle, such as quality and value, multi-factor investors can attempt to achieve a more consistent returns relative to market than single factor counterparts.
A multi-factor approach may:
- Allow an investor to address more than one objective.
- Temper factor cyclicality, smoothing the return of the portfolio relative to the cap-weighted index.
- Remove the need to try and time markets, creating a portfolio that has more balanced and diversified factor exposures.
A multi-factor strategy combines several factors in a single portfolio — offering diversification between factors and the resultant smoother return stream, without requiring monitoring of multiple portfolios.
The Move to Multi-Factor Investing
When serving as a complement to both active and traditional index strategies, smart beta may offer investors:
- Improved risk-adjusted performance potential.
Whether in the form of excess returns or improved downside protection, smart beta strategies may provide an opportunity for better risk-adjusted performance relative to traditional capitalisation-weighted indices.
- Preserves some popular features of traditional indexed strategies.
Relatively low management fees, transparency and greater flexibility make smart beta strategies attractive to investors who appreciate these features in traditional passive investments.
- Reduced manager risk.
Smart beta strategies offer more disciplined, systematic and predictable exposure to specific investment characteristics or factors. Like traditional passive strategies, this reduces the administrative burden of ongoing manager oversight.