Opinion: How Sovereign Investors Can Make the Most of Smart Beta

September 07, 2015 by SWC Editors

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Smart beta has emerged as a buzzword in asset management over the past few years, but beneath the surface of this catch-all term lies a complex and varied approach to investment, says Toby Goodworth, head of risk management at London-based investment consultancy bfinance. Sovereign wealth investors need to understand precisely what it entails and how to navigate the risks inherent in the smart-beta landscape.

By its simplest definition, smart beta — also known as alternative or advanced beta — is an index-weighting method that is not solely based on market capitalization. Recent studies have suggested that smart beta approaches lead to better long-term performance on a risk-return basis than their equivalent market-capitalization weighted indices. This concept is not new: alternative index approaches have been around for two decades, and some of the earliest current providers in the space launched in 2005.

The usual distinction made in the smart beta universe is between 'optimization' and 'heuristic' investment approaches — the former adjusts weightings to achieve a target, such as minimum variance, while the latter applies a rules-based weighting to construct an index. I extend this view by pragmatically dividing smart beta into four categories: fundamental, risk efficient, systematic risk factors and explicit weighting.

Each of these takes a distinct angle and represents a different market segment in terms of products offered. The fundamental approach is based on non-price data – essentially accounting data, such as sales, book value, cash flows etc. Risk efficient is a top-down method which evaluates the strength of a portfolio as a whole, very much akin to the 'optimization' approaches outlined above, essentially targeting specific characteristics at the overall portfolio level, such as maximum diversification, minimum variance etc. Conversely, the method of using systematic risk factors assumes a bottom-up approach, looking at constituent stock characteristics, for example quality, low volatility, momentum, high dividend yield etc., and essentially building a portfolio using quantitative methods to isolate stocks with desired characteristics from the broader universe. Finally, explicit weighting is something as simple as an equally weighted index, but still a smart beta strategy by definition nonetheless.

These alternative approaches hold a number of potential advantages over conventional market-capitalization-weighted indices. Smart beta can reduce overall portfolio volatility and provide superior risk-adjusted returns if managed correctly. It exposes investors to the benefits of a more-diversified portfolio (from a risk-factor perspective). And it takes advantage of factor tilts, returns that originate from a specific investment style.

Smart beta, because of its systematic, replicable nature, can be attractive to both passive and active institutional investors. The former typically prioritize achieving better risk-adjusted returns by making the allocation work harder, so to speak, than a traditional market cap-weighted fund, but still maintain a rules-based, transparent form of investing. For active investors, one of the main attractions of reallocating to smart beta is its lower fee structure — particularly important in a low-yield environment. Smart beta approaches offer exposure to risk premiums that tend to translate into growth over the course of economic cycles. The best value is therefore often found for investors who are seeking sustainable returns over a long-term horizon.

As with any investment strategy, this approach entails risks. One is related to the practical question of deciding how smart beta will fit into an investment portfolio. Successful management of a smart beta allocation requires a dedicated monitoring resource. Institutional investors ought to consider whether smart beta falls under the remit of their active or passive divisions. The answer varies according to circumstances and is not a matter to take lightly — getting it wrong can prevent you from making the most out of your allocation. 

A second risk is that high tracking errors are common in smart beta, something that investors reallocating from passive funds tend to have a particularly low tolerance for. Tracking errors are not necessarily a bad thing, however. In fact, tracking errors may reflect the outperformance of smart beta funds — instances in which they have consistently beaten a market-capitalization benchmark over the long run. Sovereign investors need to be guided by appropriate data.

There are also important questions related to the rigour of what is an essential part of any investor's due diligence: the quantitative analysis of track records. Because smart beta is rules-based, it lends itself well to back-testing. In light of their relatively recent emergence, however, many participants in the smart beta space have short-lived track records, and thus rely upon historical data from their current portfolios. The risk is that the reliability of this pro forma data will vary widely, with many investors overlooking significant factors, such as trading costs. While it is possible that an absence of experience in this area can be mitigated by rigorous and transparent data, investors need expertise to discern among different managers, analyze their methodology and gauge the quality of their performance.

With these risks in mind, I present below a few strategies and pieces of advice for investors to make the most out of the rise of smart beta:

  • Recognize that smart beta is an approach that works well for large-scale investments. Unlike, say, some types of assets traded in private markets, smart beta is not capacity constrained. It is therefore an excellent fit for sovereign wealth funds.
  • There is still some price discovery happening in the smart-beta space, which means there is much value to be found. The kind of large allocations that come from sovereign wealth funds are likely to result in additional pricing power because many managers are very keen to build up their assets — opening up the prospect of better deals.
  • Consider combining risk premiums to provide a tailored solution. Many risk premiums are mutually complementary, for example value and momentum, and in combination offer more attractive risk/return characteristics.
  • It is very important to evaluate the track records of fund managers pragmatically, and not be taken in by unrealistic back-tested results. 
The rapid growth of smart beta offers promising opportunities for both passive and active investors. Beware the danger of getting caught up in the hype, however: varying standards among managers' track records, implementation complications and a one-sided approach to smart beta all stand to prevent institutional investors from making the most out of their allocations, which could mean a missed opportunity for large funds in a position to secure advantageous deals. With the right approach to manager selection and an understanding of how to incorporate smart beta into larger portfolios, these risks can be controlled to open up superior long-term risk-adjusted returns, making smart beta a valued element in the asset allocation of any sovereign fund.

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