Published July 2017

Taking a smarter approach to investing

 

“Smart beta” continues to capture the attention of investors. In the latest annual smart beta survey conducted by FTSE Russell1,  60% of respondent asset owners in Europe said they had an allocation to smart beta, up from last year’s 52% and the 40% in 2015.

 

But what is smart beta?

Despite this impressive growth, the industry still lacks a common definition for smart beta. We believe that it should pass two tests:

 

1. It should be a rules-based index, just as standard “beta” is typically represented by indices

 

2. It should select and weight index constituents by something other than just geography and market capitalisation – this is where it differs from standard beta indices like the S&P 500. Here are just a few examples:

 

  • Specific characteristics of stocks such as value, growth, momentum or quality (also called “factors”)
  • Risk or volatility
  • GDP – particularly interesting in fixed income markets, where weighting by market capitalisation gives the highest weights to the most indebted countries

 

Is it active or passive?

We tend to equate  index investing with passive investing. Indices select and weight constituents using a strict set of rules, without human discretion. So, in theory at least, smart beta is passive. However, many smart beta products use concepts that are widely used by active managers – it just defines them more precisely and follows them more systematically and, arguably, makes them cheaper and easier to access via vehicles like ETFs.

 

What does smart beta do?

In practice, there are hundreds if not thousands of smart beta investments, with different objectives. To see how they might fit in a portfolio, it makes sense to divide them into two broad categories:

 

Stand-alone strategies that you might hold across the market cycle. These are often designed to replace a core beta or active strategy.

 

Tactical tools that you might use as an “add-on” to your core holdings, to tweak your portfolio during specific market conditions.

 

Whether it’s a tactical tool or a stand-alone strategy,  smart beta attempts to give you something that you wouldn’t get from investing in the broader market. Investors responding to the FTSE Russell survey said they are using smart beta strategies in their portfolios for:

 

1. Return enhancement
2. Risk reduction
3. Diversification

 

Enhancing returns

As our distinction between stand-alone strategies and tactical tools suggests, there are two broad approaches to enhancing returns.   Firstly, you could look at broad strategies – perhaps very similar to standard “beta” benchmarks in terms of the geographical or sector allocations, but aiming to give you slightly better performance.

 

One of the most popular examples is multi-factor indices. By focusing on several characteristics of stocks that each tends to outperform over the long term, e.g. value, momentum, size and quality, these strategies aims to outperform the broad market, across the market cycle.

 

Investors who want to take a more tactical approach could instead look at “single factor” products. Different factors tend to outperform at different points in the market cycle so, if you can correctly predict which factor will outperform when, and adjust your portfolio accordingly, it is possible to enhance returns.

 

Value is the most popular single factor strategy, with many ETFs – and indeed traditional funds – aiming to capture stocks displaying value characteristics, such as low Price/Earnings. Although single factors, like value, tend to outperform over the long term, they can diverge significantly from standard beta. For investors with a short or medium term outlook, timing is critical!

 

 

Reducing risk

Smart beta offers many ways to reduce risk relative to standard benchmark, some very complex and others more intuitive. The chart shows the performance of a fairly simple approach for European equities, removing the riskiest stocks and weighting the remainder so that each contributes equal risk.

 

 

Diversification

The smart beta universe provides plenty of opportunity to diversify your portfolio. You can use it to make short- or longer-term adjustments and it can complement either existing actively managed funds or pure beta exposures.

 

Get in touch with Source ETF

We have pioneered the use of smart beta, making a range of different tools and strategies available to investors in Europe through ETFs. If you would like to learn more, please get in touch.

 

Visit Source ETF here

 

 


 

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1. [Smart beta: 2017 global survey findings from asset owners ]Back to text