Due Diligence Checklist for Smart Beta

Manager Expertise

  • How experienced is the manager in factor research and factor- portfolio implementation?
  • Has the manager articulated the metrics/objectives they are striving to deliver when building the strategy? (E.g., lower tracking error, factor exposure per unit of tracking error, etc.)
  • What makes the manager distinctively better in constructing Smart Beta strategies, compared with other providers?

Approach To Factors

  • How are factors selected?
  • What is the rationale used to select metrics for the factors?
  • What makes the manager’s selection of metrics more robust compared with other providers?

Portfolio Construction Methodology

  • Does the manager use a top-down (combining single factor portfolios) or bottom-up approach (creating a multi-factor portfolio from individual stocks) approach? What is the manager’s rationale for doing so?
  • How is the portfolio constructed? Tilted (non-market cap weighted) or optimized?
  • Are there specific guidelines cited for concentration?
  • Is the methodology transparent and readily available?
  • Is the selection/weighting methodology a function of the objectives for the strategy?
  • Is there a prudent process for controlling other risk exposures (sectors, countries, turnover, etc.)?

If the portfolio is optimized, consider:

  • Which objective function and risk model is used and why?
  • Why does the manager use the cited constraints?
  • Is there a prudent process for controlling other risk exposures (sectors, countries, turnover etc.)?

Multi-Factor Framework

  • Why are the specified factors chosen to create a multi-factor strategy?
  • How does the strategy ensure consistent factor exposure?
  • Are there constraints on exposure to the factors that the strategy is designed to maintain?
  • Does the strategy employ factor timing?
  • If the manager uses factor timing, what signals are employed? What is the time horizon for the timing model? Is the model transparent and robust?
  • Does the strategy account for concentration?

Risk Management

  • How often is the strategy rebalanced? What is the rationale of the manager behind the choice of rebalancing frequency?
  • How are trading costs taken into consideration in the strategy?
  • Can the manager leverage internal crossing networks?
  • How is liquidity risk addressed?
  • Is the strategy designed to have a certain level of tracking error? How is this handled in the methodology?
  • Is the strategy susceptible to capacity risk? How is this handled in the methodology?
  • How are unintended risk exposures controlled?

 

Disclaimer

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Investing involves risk including the risk of loss of principal.

The whole or any part of this work may not be reproduced, copied or transmitted or any of its contents disclosed to third parties without SSGA’s express written consent.

Equity securities may fluctuate in value in response to the activities of individual companies and general market and economic conditions.

Investments in issuers in different countries are often denominated in different currencies. Changes in the values of those currencies relative to the Portfolio’s base currency may have a positive or negative effect on the values of the Portfolio’s investments denominated in those currencies. The Portfolio may, but will not necessarily, invest in currency exchange contracts or other currency-related transactions (including derivatives transactions) to reduce exposure to different currencies. These contracts may reduce, take or eliminate some or all of the benefit that the Portfolio may experience from favorable currency fluctuations.

While diversification does not ensure a profit or guarantee against loss, investors in Smart Beta may diversify across a mix of factors to address cyclical changes in factor performance. However, factors may have high or increasing correlation to each other.

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.

The stock/funds employs a value style of investing that emphasizes undervalued companies with characteristics for improved valuations, which may never improve and may actually have lower returns than other styles of investing or the overall stock market.

A “quality” style of investing emphasizes companies with high returns, stable earnings, and low financial leverage. This style of investing is subject to the risk that the past performance of these companies does not continue or that the returns on “quality” equity securities are less than returns on other styles of investing or the overall stock market.”

The stock/funds employs a momentum style of investing that emphasizes investing in securities that have had higher recent price performance compared to other securities, which is subject to the risk that these securities may be more volatile and can turn quickly and cause significant variation from other types of investments.

Low volatility stocks/funds can exhibit relative low volatility and excess returns compared to the Index over the long term; both portfolio investments and returns may differ from those of the Index. The fund may not experience lower volatility or provide returns in excess of the Index and may provide lower returns in periods of a rapidly rising market. Active stock selection may lead to added risk in exchange for the potential outperformance relative to the Index.

The views expressed in this material are the views of SSGA through the period ended March 31, 2018 and are subject to change based on market and other conditions. This document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected.

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