‘Smart Beta’: Bridging Active Vs. Passive

November 26, 2014

This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today’s article is by K. Sean Clark, chief investment officer of Philadelphia-based Clark Capital Management.

While “smart beta”—also called strategic beta—has become a buzzword, the concept is far from new.

Institutional investors have used alternative weighting and factor-driven strategies since the 1970s, though no one called them “smart beta” back then. Now that the term has become mainstream, nonmarket-cap-weighted ETFs have gained steam.

“Smart beta” approaches are currently the fastest-growing segment of the ETF marketplace, pulling in assets at twice the rate of the entire ETF market.

We’ve used a number of these sorts of ETFs, including the PowerShares S&P 500 Low Volatility Portfolio (SPLV | A-47), one of the first of its kind that has been available to investors since May 2011. It now has almost $4.75 billion, making it very liquid and very tradable.

But before getting too much into specific vehicles, let’s define “smart beta” a bit more precisely and situate that in terms of how investors might use it.

What ‘Smart Beta’ Is

One complication of smart beta is that it lacks a standard industry definition. For the purposes of this article, we’ll use the following definition from Investopedia:

“The default setting for an ETF, a non-strategic beta ETF, is to be tied to an index whose components are weighted by market capitalization … A strategic (or “smart”) beta ETF, on the other hand, has its components weighted by some other criteria.”

At Clark Capital, it’s our belief that smart beta strategies offer exposure to the best of active as well as passive strategies, providing investors a valuable alternative that expands portfolio construction opportunities.

In my last ETF.com article, Moving Beyond Active Vs. Passive Debate, I discussed how the two styles of investment management complement each other, help build a more robust portfolio, and aid in risk management and diversification.

We believe that smart beta bridges the gap between active and passive. As Ben Johnson, director of Passive Funds Research at Morningstar, put it: “The common thread among [smart beta ETFs] is that they seek to either improve their return profile or alter their risk profile relative to more traditional market benchmarks.”

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Advantages & Disadvantages Of Smart Beta

In our opinion, to use smart beta effectively, you need to:

  1. Be able to identify which factor(s) can produce alpha
  2. Be able to identify when that factor will come in and/or out of favor via a market environment change

You may also need to overcome some disadvantages of smart beta; namely, the following:

  1. Ask yourself, does the expected alpha overcome higher expense ratios?
  2. More concentrated portfolios can increase return but they can also increase stock-specific risk.
  3. Wider spreads on trading these less liquid products require one to ask whether the expected alpha outweighs the risks.

For decades, active mutual fund managers have used factors such as dividend growth, earnings growth, balance sheet quality and momentum to manage equity mutual funds.

In fact, Clark Capital uses these factors in several of our own investment strategies. Investors should be able to benefit by having access to these factors in an ETF form, but only if they can figure out how to properly use them.

Smart-beta strategies provide a tool kit for accessing investment factors such as low volatility and momentum, enabling advisors to take positions with intended consequences. Smart-beta ETFs have combined active and passive management, which we believe may lead to an improvement upon a traditional market-cap-weighted index. And they are down in at least seven ways:

  • Dividend (growth or yield)
  • Earnings
  • Volatility/Beta
  • Quality/Fundamental (balance sheet factors)
  • Buybacks
  • Momentum
  • Equal Weight Indexes

We believe managing risk to the upside and downside via low-volatility and higher-volatility ETFs seems to be the most valid use of smart beta. Some examples of ETFs we have used to tactically shift a portfolio’s risk are:

Because smart beta is such a broad and complex investment category, it’s important to identify clients’ personal objectives and the outcomes they are trying to achieve. As with any relatively new investment category, we recommend dedicating ample time to research and education and/or seeking out a manager with a seasoned track record in the space.

Clark Capital Management Group is an independent investment advisory firm providing institutional-quality investment solutions to individual investors, corporations, foundations and retirement plans. Clark Capital was founded in 1986 and has been entrusted with approximately $3 billion in assets. For more information about Clark, contact Advisor Support at 800-766-2264 or [email protected]. Please click here for a complete list of relevant disclosures and definitions.




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