Smart Beta Vs. Factor Funds: What's The Difference?

May 10, 2018

[This article appears in our June 2018 issue of ETF Report. Also, join at the Inside Smart Beta & Active ETFs Summit June 6-7, 2018 at Convene Midtown West in New York.]

The two terms are often used interchangeably, but that approach overlooks important nuances. And by missing those nuances, advisors and investors could be making some costly errors by their lack of understanding.

Rob Arnott, founder and chairman of Research Affiliates, said the term “smart beta” was coined by London-based consulting firm Towers Watson in 2007, and the inspiration was fundamental weighting. That strategy works by trimming positions in companies whose price is rising but their fundamental value isn’t changing, and buying companies whose prices are falling but their fundamentals remain the same. By breaking the link with price, it forces the index to rebalance against the market’s most extreme bets, he says.

“They said, ‘that's smart. We should tell our clients to diversify their core risk … and split their money between index funds and one of these smart-beta strategies,’ Arnott said. “Well, the term became popular because pretty soon everybody was wanting to say ‘we're studying smart beta.’”

Factor investing, meanwhile, was focused on academic work by University of Chicago professors Eugene Fama and Kenneth French (now at Dartmouth), as an asset pricing model, with Mark Carhart of the University of Southern California expanding on their work with his own model. There are five main factors associated with higher returns that are widely used in factor ETF strategies: value, small-caps, momentum, low volatility and quality (which is also known as dividend payers). A sixth factor, yield, is sometimes included in the main factor definition count.

Arnott says that since fundamental weighting has a value tilt because it’s always buying out-of-favor companies, the factor community embraced the term smart beta. And this may be where some of the blending of the two terms may have occurred. But Arnott says because factor investing begins by using a market-capitalization weight and then adds a factor tilt, it isn’t smart beta.

“There's nothing about factor tilts that make them smart beta under the original definition, but I've lost that fight,” he said. “The marketplace now says factor strategies or smart beta. I disagree, but I don't define the semantics of our industry.”

Blurred Definitions

Sal Bruno, chief investment officer of IndexIQ, agrees that, as smart beta has evolved, the term itself has been stretched. “I think they get conflated because it's sort of everything that's not market-capitalization weighted kind of gets thrown into this smart-beta definition,” he said, noting some other terms like “alternative weighting” or “alternative beta.”

Factor investing itself has become stretched beyond the Fama-French research, and Bruno says that’s a problem. The original factors have the name of the factor embedded in research, such as “high minus low,” showing that it was long one characteristic and short another to become neutral to the market, he notes.

“The pure factor is important from a research and academic perspective, because if you don’t do that, you end up including too much of the market effect, which is its own factor,” Bruno added.

Mike Venuto, chief investment officer of Toroso Investments, says defining what a factor is and what it isn’t may have also led to confusion. There are the original Fama-French factors, but some people are using nonacademic definitions—such as environmental, social and governance tilts or share buybacks—and calling them factors. Some of those may not have as rigorous research, but he says they still may might be considered factors.


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