Debated over whether it is fact, fiction, marketing or all of the above, “Smart Beta” had been a growing point of contention in the asset management industry recently. Our view, based more on the math than the marketing, is that these strategies are deserving of the attention and assets they are garnering, and advisers would be well served to consider them.
The term “Smart Beta” refers to the gray area that strategies which aren’t quite active management, but aren’t quite indexing, occupy. Smart beta strategies could just as easily be called quantitative strategies, if the word Quant hadn’t already scared everyone to death in August of 2007. The majority of these strategies use the following approach: 1. Start with a widely-held index. 2. Determine via multiple-regression and factor analysis which aspects of the securities in the index tend to identify outperformance. 3. Systematically allocate to the securities with the highest concentration of the good factors and the lowest concentration of the bad factors.
Where it exists, the outperformance comes from the homework of the quantitative analysts before the trades are implemented. Once the securities are selected, they are often bought and held until the next quarter/year, when the same algorithms are run again to select the securities which now rank highest in the factor analysis.
Passive strategists have argued that smart beta strategies can’t work, because if everyone is doing it, there won’t be any outperformance available. While this statement is absolutely true, it is also irrelevant, because everyone isn’t going to implement these strategies. The same rule applies for why an increase in the number of indexing investors causes an increase in the amount of available alpha for the active management world. Market inefficiencies are finite and the more people sharing in them, the less there is for each individual participant.
ABOUT THE NAME
Was it Smart Beta when the Fama-French Three-Factor-Model described a stock’s returns being comprised of its beta, but also of its market capitalization (bias toward small caps) and price-to-book ratio (bias toward value)? Was it Smart Beta when Cliff Asness showed consistent outperformance by stocks that had demonstrated price momentum?
These well documented (University of Chicago) investment analyses, along with many other Smart Beta strategies, are producing higher returns than their given index, without a proportionate increase in volatility. Statistically, those excess returns are referred to as alpha, not smart beta. Jack Bogle is probably right that the term is more marketing than definitional, but for an industry that has been inundated with conflicting messages about the efficacy of active management, new nomenclature that provides a fresh start to outperforming a “buy everything” approach is welcomed in our view.
While these strategies can come with a lower price tag than many traditional actively managed funds, the potential alpha they can generate, and the processes they use, are comparable. Many asset managers pride themselves on a repeatable process in their fundamental analysis – Smart Beta simply takes the repeatable aspect to the next level. Signals and factors that aided bottom-up portfolio managers decades ago can now easily be codified and tested against the universe of investable assets, with an incredible savings in time and manpower, which is largely being passed on to the investor.
As Smart Beta products proliferate, the opportunities to implement strategies that harness quantitative descriptions of well documented market inefficiencies become cheaper and more prevalent – all of which constitute a huge positive for investors.
Dave Donnelly is the Founder and CEO of Strategic Alpha, a rebalancing service dedicated to helping financial advisors improve client outcomes. www.Strategic-Alpha.com