Smart Beta: The Next Generation

February 10, 2015

SmartbetaNextGenerationCover

With global growth projections rising and confidence returning, albeit gradually, signs remain that the worst economic crisis the world has seen since the Great Depression has left some remarkably deep scars on the psyche of players in the investment world. This has led to an increased demand for safe but innovative investment products, smart beta being one of them. This is coupled with a demand for yield in an artificially low rate environment alongside a well performing stock market. This landscape of higher returns and lower risks brings us back to the financial academics' basics of breaking down returns into factors.

Early versions of smart beta have now been launched, tested and found to be resilient by market players. Smart beta has become such a hot topic that some traditional index providers are claiming they have been providing smart beta indexes for decades. Buoyed by this initial response some feel that smart beta version 2.0 is on the horizon. But what else can smart beta bring to the table; how "smart" can it actually be? Will v 2.0 be something more akin to dumb alpha? Or will it evolve into something completely new?

Smart beta originally sprung out of academic theory, beginning with Harry Markowitz's seminal 1952 paper which established that portfolio diversification could maximise investor returns and lower risk.1 Taking its name from "beta", meaning subject to overall market performance, and "smart", meaning outperformance, beating the market is what smart beta is all about. The idea behind smart beta is not to follow market cap weight, unlike passive index funds. The stock market crash of 2008 tarnished market cap indexes because they were deemed biased to past success and risk due to excessive concentration, thus creating bubbles prior to market downfalls.2

Academics have demonstrated over the past 40 years that strategies proven to beat beta do exist. Equally weighting stocks is one method; emphasising low price-to-book ratios another. In the last few years the industry has further developed smart beta into a number of different indexes including fundamentally weighted, low volatility, maximum Sharpe ratio and momentum.3

Systematic Systemic Allocation Strategy
Today's smart beta products fit neatly into the traditional style and market cap boxes, which is a context that investment professionals can leverage. There are, however, strategic and tactical decisions regarding asset allocation that, nevertheless, still require an adviser or asset manager to decide which strategy will work, and when. While attempting to follow the numerous and complex factors within the overall global economic cycle, the ability to react in a timely manner is essential if opportunities are not to be missed. Think about it as market timing, but instead of stock picking, it is portfolio construction and style tilting. A deep value fund, for instance, can in general outperform the market. The investor, however, may be subject to wide performance swings through which growth may, at times, actually outperform value. The challenge is to then change portfolio allocation quickly to avoid the periods of value underperformance, which is fundamentally a matter of market timing - still very much an active strategy.

A systematic allocation strategy would essentially follow certain smart beta indexes and automatically shift the allocation from value to growth based on determined metrics. At a very high level, today's investor still needs to make an active decision when choosing the region in which to invest (e.g. Europe, Emerging Markets or the U.S.). True smart beta, or outperformance, can come as a result of being able to use metrics, such as economic data, to shift global equity portfolios into economies that have superior performance.

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