Needle in a Haystack: How to Find the Right Smart Beta Strategy
Demand for smart beta strategies is growing, and as such, supply is too. Such a crowded landscape demands investors conduct ample due diligence before choosing the right smart beta strategy to meet their requirements.
Smart beta – also known as strategic beta or factor investing – largely refers to a category of rules-based approaches to investing. These strategies seek to capture specific characteristics that traditional active managers commonly seek exposure to, and while doing so preserving the benefits of traditional indexed investments, including transparency, consistency and low cost.
Evaluating a Smart Beta Strategy
There are a range of simple and measurable metrics, such as liquidity, factor exposure, active risk relative to a broad market index, resultant performance and, of course, cost that need to be taken into consideration when evaluating smart beta ETFs.
The following is a summary of some of the key items to consider and key questions to ask when choosing the right smart beta ETF to best meet your investment requirements.
Understand the factor exposure of the existing portfolio.
This is important because understanding your existing factor exposure will enable you to identify factors that complement your current strategies.
Questions to ask:
What is the factor exposure of your existing portfolio?
Choose the factor(s) you wish to capture that aligns with your investment goals.
It is important to ask yourself what your investment goals are – enhance returns, reduce risk, or a combination? This will drive which factor(s) you want to capture in the portfolio, and whether you require single-factor or multi-factor exposure. As the name suggests, single-factor funds focus on a single factor, such as value or momentum, when investing, while multi-factor funds focus on different factors when organising the weights of a given index.
Questions to ask:
What are your investment goals?
Are you looking for single-factor or multi-factor exposure?
Understanding the use of the smart beta fund is also key
will it be used as a replacement for a broad market capitalisation index fund or for an active fund? Or as a complement to existing indexed or active holdings? This will drive the index construction methodology to use. For example, a smart beta ETF may be more suitable to replace an active fund which is usually less benchmark aware and holds more concentrated positions compared to broad market portfolios.
Finally, the overall risk tolerance of the portfolio should also be considered. Factor risks should be considered in the context of the overall risk tolerance of the portfolio, so how much risk budget are you allocating to your smart beta ETF, what does risk mean to you?
Questions to ask:
How will the smart beta fund be used?
What is the overall risk tolerance of the portfolio?
Understand the index construction and historic performance.
There are a number of factors to consider here. Variations in index construction may result in different levels of factor exposure, thus yielding different performance results. In addition to this, understanding what metrics were used to select the index constituents will enable you to understand how the index captures the factor premia. Differences in weighting methodology and rebalancing frequency may lead to different sector allocations and index turnover, while the tracking error helps quantify the risk level of the factor-based strategy. It is also crucial to find out how the index/fund performs in different market environments, as this can help you set reasonable performance expectations.
Questions to ask:
Does the smart beta index include all constituents of the market-cap weighted index but reweighted based on their fundamentals, or only a subset of the index constituents?
What metrics are used to select the index constituents?
What is the factor weighting methodology and rebalancing frequency of the index?
What is the tracking error relative to a market cap weighted index?
How does the index/fund perform in different market environments?
Further Considerations for Multi-Factor Exposure
For investors seeking multi-factor exposure, it is important to go one step further. The correlation between factors needs to be considered, as factors that are highly correlated may exacerbate underperformance during certain market environments. Depending on the level of experience, investors may be looking to blend a few single factor products, or perhaps use a multi-factor product which employs pre-defined rules to allocate between/among factors. Factor timing requires a sophisticated and advanced framework that may be better left up to skilled active managers. The weighting of factors is also key, as this can address investors’ targeted objectives, such as income generation or volatility reduction while still mitigating single factor cyclicality.
Questions to ask:
What is the correlation between/among factors?
Are you looking to blend a few single factor products at your own investment discretion or use a multi-factor product which employs pre-defined rules to allocate between/among factors?
How do you capture multiple factors in one portfolio?
How are factors weighted?
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.
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