What is Smart Beta?
The rising popularity of smart beta strategies is shaking up the investment world. In an environment of potentially extended low growth, and increased uncertainty, smart beta gives investors the opportunity to potentially achieve higher returns than the traditional market-capitalisation indices while lowering costs.
Smart beta – also called strategic beta, factor investing, and a few other related terms – generally refers to a category of rules-based approaches to investing. These strategies seek to capture specific factors, or investment characteristics such as value and quality, that active managers commonly seek exposure to, while preserving the benefits of traditional indexed investments such as transparency, consistency and low cost.
Delivering excellence in smart beta
Assets Under Management 1
Dedicated Portfolio Managers
The five most common smart beta factors shown to drive returns and outperform the market capitalisation benchmark over the long term are:
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 term, potentially due to investors’ behavioural biases and the reward for taking additional risk/providing liquidity in a stressed environment.
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,2 especially in times of market stress when a company’s ability to service debt and provide visibility on earnings become more important.
Small-capitalisation stocks have tended to outperform their large-capitalisation peers over time.3 There are a number of potential drivers for the long term strong performance of smaller capitalisation stocks. Their smaller size means they are generally considered to be riskier (less diversified, less covered by analysts and less well known), which has two implications. Firstly, investing in small capitalisation stocks requires a well diversified portfolio to reduce stock specific risk; secondly, the market demands a higher expected rate of return for holding these stocks – the so-called “small capitalisation premium”.
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.
Empirical evidence shows stocks that have done well recently may have greater potential of doing well in the near term than the broader market, and stocks that have performed poorly continue to perform poorly.4 Portfolios that consider momentum can benefit from the momentum in securities over the shorter term.
While different firms recognise slightly different factor lists, the factors above appear in most published lists.
In addition to this list, some firms recognise ‘Yield’ as another factor. This states that over the long term, stocks with higher dividends tend to perform better than stocks with lower yields. This is typically linked to the Value and Quality factors.5
The above factors perform differently in different market conditions. Quality and low volatility strategies tend to outperform in market downturns, while Value strategies usually deliver strongest returns in risk-seeking environments.
When you are constructing client portfolios consider which factor to capture. Alternatively, a strategy that combines multiple factors in a single portfolio — or a multi-factor smart beta strategy — offers diversification throughout the business cycle, with at least one factor working in favour with the business cycle when others drag. The potential result is a more consistent and smoother return stream over the long run.
Active managers have long harnessed the power of factors to beat their benchmarks over time. The difference with smart beta is it seeks to harness this power of factors by using a systematic, low-cost and transparent approach more synonymous with indexed investing.
When you are considering the construction of a client’s strategy use an index that’s specifically designed to screen for the desired factors. This rules-based approach can potentially result in consistent positive exposure to the desired factors over time as well as cost reduction.
Benefits of Smart Beta
When serving as a complement to both active and traditional index strategies, smart beta may offer investors:
Accessing Multi-Factor Smart Beta with SPDR® ETFs
There are a growing number of smart beta strategies now offered in Australia, with exposure to both single and multi-factor strategies. For example, the SPDR® MSCI World Quality Mix Fund (QMIX) is an ETF traded on the ASX, which provides exposure to over 500 large to mid-capitalisation stocks in more than 20 developed nations, including Australia. The Fund seeks to track the performance of the MSCI World Factor Mix A-Series Index which aims to represent the combined risk/return performance characteristics of quality, value and low volatility factors within global developed equities.
Investors should conduct ample due diligence before choosing a smart beta fund, as not all are created equal. Knowing what lies beneath the label can assist investors to make better decisions on when, how, and why they may want to implement smart beta within a portfolio. Investors should work with their financial advisor to find the right strategy for their individual risk tolerance level and objective.
Interest in smart beta is growing – at the end of December 2018, there were 1,493 smart beta equity ETFs and ETPs globally.6 Within such a crowded landscape, investors need to conduct ample due diligence before selecting a strategy.
We have created a thorough framework for investors to consider when choosing the most suitable smart beta ETFs for their investment strategy.
1 As of 31 March 2019. All figures in USD.
2 “The cross-section of expected stock returns,” Fama, E. & French, K., Journal of Finance, as of 6/1992, 47, 427 –465. Fama, E., & French, K., “Common risk factors in the returns on stocks and bonds,” Journal of Financial Economics, Volume 33, issue 1, as of 6/1992, 3 –56
3 “The cross-section of expected stock returns,” Fama, E. & French, K., Journal of Finance, June 1992, 47, 427 –465; Fama, E., & French, K., “Common risk factors in the returns on stocks and bonds,” Journal of Financial Economics, Volume 33, issue 1, as of 6/1992, 3 –56
4 “Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency,” Jegadeesh, Narasimhan and Titman, Sheridan, The Journal of Finance, Vol. 48, No. 1, as of 3/1993, pp. 65 –91
5“Stock Returns and Dividend Yields: Some More Evidence,” Blume, M.E., The Reviewof Economics and Statistics, 1980, 62 (4) 567 –577
6Morningstar Direct, Morningstar Research, as at 31 December 2018.
A Smart Beta strategy does not seek to replicate the performance of a specified cap-weighted index and as such may underperform such an index. The factors to which a Smart Beta strategy seeks to deliver exposure may themselves undergo cyclical performance. As such, a Smart Beta strategy may underperform the market or other Smart Beta strategies exposed to similar or other targeted factors. In fact, we believe that factor premia accrue over the long term (5-10 years), and investors must keep that long time horizon in mind when investing.