Smart beta, scientific beta, factor models, fundamental indexation.....
Whatever you want to call it, smart beta strategies are trending. In the space of a few years, the smart beta philosophy has won over hearts and minds in the investment world. The number of smart beta products - indexes, ETFs and manager strategies - is growing rapidly.
For pension funds, smart beta is the flavor of the month, with many high profile funds having increased their allocations to smart beta strategies.
Even the "Economist" magazine has noticed, with an article asserting that — despite a terrible name — “the concept is catching on,” with strong inflows of funds.
What is smart beta?
Although not all practitioners will agree on a precise definition of smart beta strategies, the concept is not difficult. "Beta" is about achieving the market return. "Alpha" is about performance relative to the market. "Smart beta" is about passive tracking of an index that is likely to beat the traditional, market-cap weighted index.
Smart beta might be thought of as one step removed from index investing - managing a portfolio passively, but seeking intelligently to outperform the traditional index. The next logical step down this path, might be to implement a modest, factor-based tilt to an index portfolio.
With "factor investing" portfolio exposures are measured by reference to "risk factors", rather than by reference to commonly-used sector definitions.
Why does smart beta work?
A portfolio which tracks a market cap-weighted index will tend to build higher stakes in stocks which have gone up in value, and may have become overvalued. Smart beta strategies try to counter this by following an index which is not price-driven.
Furthermore, historically some "risk factors" (such as company size, value/dividend yield, low volatility, momentum) have demonstrated persistent outperformance. Therefore adjusting (or tilting) an index to have greater exposure to these factors might be expected to produce above-index returns over the long-term.
Many quant-aware managers have been practicing some kind of factor tilts for some time, long before the name "smart beta" entered the investment dictionary.
What are the problems?
Well.....firstly, if everyone was doing it, then it wouldn't work. Any benefits would be arbitraged away - or potentially reversed (if factor exposures become "overvalued" they will eventually generate negative alpha)..
Secondly, there is a growing number of apparently "smart" risk factors being proposed. But which of these will actually generate persistent added value, and which are the result of spurious and over-enthusiastic data-mining? The papers below help with this.
Thirdly, should "smart beta" be a passive "buy-and-hold" strategy, or should it be an actively managed strategy, seeking to favour specific risk factors at different times?
Smart Beta Research - our twelve top white papers
The research below address all of these issues and questions. In no particular order, here are our top 12 white papers on factor investing and smart beta.
This comprehensive 220 page report examines the relative efficiency of a variety of common factor investing strategies for equities, bonds and commodity portfolios. The authors recommend the use of "replicating portfolios" to represent risk factors, and find that the added value from factor investing is magnified if short-selling is permitted.
In this 12 pager, bfinance examines ‘alternative beta’, which extends beta investing into the alternative investment space . There is no widely-accepted definition of "alternative beta", but bfinance explains it as a systematic and passive capture of risk premia beyond traditional equity, bond and credit market exposures, using alternative investment techniques. For instance, common hedge fund styles and strategies can be replicated using systematic algorithms which mimic those strategies. For this reason, alternative beta is sometimes referred to as ‘hedge fund beta’.
The authors from Northern Trust argue that risk factor exposures should not be adopted in a passive "buy-and-hold" manner. Instead, they argue that market timing of risk factors can, and should be employed in order to maximise added value.
This paper examines the value and persistence of factor investing strategies which actively depart from market cap portfolio weightings. The authors discuss whether factor investing will stand the test of time, exploring common frameworks, applications and practical considerations.
5. Scientific Beta Multi-Strategy Factor Indexes: Augmenting Factor Tilts with Better Diversification (Edhec, 2015)
This paper from Edhec argues that market cap based indexes have two main problems; firstly they have unwanted factor exposures, and secondly they have an undesirable level of concentration in big stocks. However, the authors suggest that many asset managers implementing smart beta strategies have not fully addressed these two shortcomings. The authors introduce Edhec's "Scientific Beta" factor indices which provide exposures to desirable risk factors, but diversify away from uncompensated risk.
6. A Framework for Assessing Factors and Implementing Smart Beta Strategies (Research Affiliates, 2015)
Published in the Journal of Index Investing, this article argues that the academic literature is littered with a "zoo" of apparently "smart" risk factors, which in practice will go unrewarded, being the result of spurious and unwarranted data-mining, The authors suggest a methodology whereby robust, investable, risk factors can be identified, which make intuitive sense and are supported by empirical research which spans geographies and time-frames, and which are not undermined by small changes to definition.
As Smart Beta and factor strategies become increasingly popular, will this impact their performance? Certainly, persistent outperformance from systematic strategies seems to run contrary to efficient markets theory. In this 18 page document, S&P Dow Jones examine the arguments.
In recent years, the number of "smart beta" equity indices has increased dramatically, most aiming to exploit the same risk factors such as value, low vol, size or dividend yield. In this paper, Northern Trust introduces a new metric, the Factor Efficiency Ratio (FER), which is designed to measure the extent to which a smart beta index captures intended exposures to risk factors and minimizes unrewarded factor exposures.
Many users of smart beta adopt a “Monkey portfolio” philosophy, believing that smart beta strategies can be deployed naively, with the assurance that all such strategies will add value. Edhec's research warns that this is unwise, as many smart beta strategies have exposure to uncompensated risk factors. The authors caution that diligence is required to prevent over-extrapolation of specific smart beta test specifications into a broader context.
This annual guide from Morningstar reports on the global marketplace for strategic beta ETPs - a sector of the market experiencing fast growth. The authors expect this growth to continue, with new players entering the market and new, previously unrecognized strategies being offered. Morningstar expect the landscape to become increasingly competitive, exerting downward pressure on manager fees.
With a "zoo" of risk factors being proposed for smart beta or asset allocation purposes, how can we discern which factors are actually likely to persist in the future? Jason Hsu suggests that investment researchers now do so much data-mining that the standard t-statistic of 2 can no longer be relied upon to validate a "smart" risk factor. Instead the t-statistic required should be adjusted to allow for the quantity of data-mining that is happening.
From Jason Hsu of Research Affiliates; a collection of short articles which form a useful introduction to the key concepts of smart beta strategies. Topics cover how "fundamental indexation" differs from normal, cap-weighted indexation, how periodic rebalancing is akin to dollar-cost averaging, and other short topics.