Smart beta investments have exploded in popularity in recent years, gathering assets at a rapid pace while inspiring a wave of new products from investment firms eager to grab a share of a growing market.
BlackRock, the world’s largest asset manager and a leading provider of smart beta products, projects that smart beta exchange-traded fund assets will reach $1 trillion by 2020 and $2.4 trillion by 2025.
Smart beta products are factor-based investment strategies used by investors seeking an edge over market-capitalization-based index strategies. Smart beta also appeals to investors frustrated with the lagging performance and high fees of many actively-managed investment products.
Academic research is at the core of the smart beta phenomenon, providing a large body of research identifying factors that explain investment return and risk. Smart beta strategies attempt to use factor-based approaches to enhance risk-adjusted returns relative to traditional indexes, most commonly using the following factors:
— Value: “Inexpensive stocks outperform expensive stocks”
— Size: “Small company stocks outperform large company stocks”
— Low volatility: “Less volatile stocks outperform the most highly volatile stocks”
— Quality: “Stocks with high earnings quality outperform stocks with low earnings quality”
— Momentum: “Winning stocks keep winning, losing stocks keep losing”
— High dividend: “Higher income stocks provide superior returns”
[See: 13 Ways to Take the Emotions Out of Investing.]
Smart beta strategies occupy a middle ground between passive and active investment approaches. Smart beta funds are similar to passive index funds in their use of a systematic, rules-based framework to create portfolios. Smart beta strategies deviate from traditional index funds by emphasizing factors that may enhance returns relative to capitalization-weighted indexes.
With the goal of “beating” an index, smart beta strategies occupy common ground with traditional actively-managed strategies. The rules-based approach is a differentiating characteristic for smart beta strategies, which avoid the subjective overlay found in most traditional active management approaches. Most smart beta strategies are tightly risk controlled, accepting slightly more risk than the index in order to capture incremental factor-based returns. Most smart beta products offer a middle ground in fees as well, carrying slightly higher fees than index funds but lower fees than most actively-managed funds.
Market capitalization-weighted indexes include the aggregate holdings in the market, investible with low turnover, high liquidity and capacity. Smart beta strategies may not provide the market coverage of traditional indexes, potentially leaving portfolio “gaps” relative to the broad market. Smart beta strategies may also provide a more volatile “ride” than traditional indexes.
Although long-term returns from factor premiums have outpaced the market, annual factor returns have varied widely and individual factors can be out of favor for extended periods of time. Notably small company stocks lagged large company stocks for much of the 1990s, and value stocks performed poorly relative to growth stocks during the late 1990s technology bubble. Small company stocks and value stocks were stellar performers during other periods, rewarding patient investors who stayed the course.
Researchers have devoted considerable time in an effort to explain factor premiums. A variety of theories have been offered to explain factor premiums and demonstrate why factor premiums would be expected to continue in the future.
Although research findings are far from conclusive, there are plausible explanations for the existence of factor premiums. Some researchers think that factor premiums represent compensation for systematic risk. For example, small companies may be less liquid, more volatile or have greater vulnerability to bankruptcy. Consequently investors must be “rewarded” for taking the incremental risk of investing in small companies. Time horizon may also play a role in factor premiums, as investors may receive a premium for longer-term, less liquid investments.
Other researchers point to behavioral biases in explaining factor premiums. Loss aversion, preference for lottery-like opportunities and tendency of investors to chase recent winners are among the most commonly-cited behavioral theories. Factor premiums associated with systematic risk factors are considered to be more likely to persist, while behavioral biases may reverse if investors recognize and modify their behavior.
[See: 9 Psychological Biases That Hurt Investors.]
Smart beta strategies can be based on a single factor such as style or size, or can combine multiple factors to dampen volatility or enhance returns. Some smart beta providers argue that diversification across factors can reduce the length of underperformance when one or more factors is out of favor. For example, value and momentum factors are negatively correlated so a strategy that combines both factors may offer a less volatile investment experience. Some smart beta providers combine factors as a return enhancement device, reasoning that a stock that carries multiple factors may outperform a stock that only carries a single factor.
The explosion in popularity of smart beta concerns some investors. Future returns for smart beta could be compromised by the growth in assets devoted to smart beta strategies, as well as rising awareness about factor premiums. BCA Research recently reminded readers of an insightful quote from the late Barton Biggs, “there is no investment idea so good that it can’t be destroyed by too much money.”
In the near-term, the interest in smart beta may contribute positively to performance, but there is a risk that a smart beta “bubble” could burst if these factor-based strategies become saturated with investor cash. However, given the systematic and behavioral underpinnings behind factor premiums, the benefits of smart beta may decline but not disappear.
Investors thinking about smart beta should consider the following:
Be realistic about return expectations. Past performance is no guarantee of future performance, particularly when prior results are from simulations using historical data. Given the increasingly popularity of smart beta products, it’s likely that future return premiums will be lower than historical return premiums.
Determine the portfolio role for smart beta, and select the investment that is the best “fit” for the role. Single factor, standalone smart beta strategies may be appropriate for portfolios using smart beta as a supplement to traditional market-capitalization-weighted index funds or diversified portfolios of active funds. Conversely, some investors may prefer a multi-factor approach to reduce single factor volatility if smart beta is used in place of traditional index funds.
Understand the portfolio turnover and tax implications of smart beta strategies. Smart beta strategies can differ dramatically, with momentum strategies meriting particular attention. Momentum strategies typically turn over at a rapid rate, potentially creating high tax bills if held in taxable accounts.
Understand the “natural habitat” and implementation approach of smart beta strategies. Some smart beta strategies may concentrate in a limited number of sectors. For example, in recent years, dividend and low volatility strategies have had significant holdings in utilities and consumer staples stocks. Some smart beta products will limit sector concentration, while others have less restrictive approaches. Understanding the details behind investment selection and implementation will help investors avoid unintended portfolio concentration.
Be patient. Smart beta strategies can be highly cyclical, and can remain out of favor for extended periods of time. It is important to develop expectations about how the smart beta strategy will perform when the strategy is out of favor. Establishing realistic expectations increases the likelihood of sticking with smart beta during periods in which the strategy is out of favor.
[See: 10 Skills the Best Investors Have.]
Investments in securities are not insured, protected or guaranteed and may result in loss of income and/or principal. This communication may include opinions and forward-looking statements. All statements other than statements of historical fact are opinions and/or forward-looking statements (including words such as believe, estimate, anticipate, may, will, should and expect). Although TFC Financial Management believes that the beliefs and expectations reflected in such forward-looking statements are reasonable, it can give no assurance that such beliefs and expectations will prove to be correct. Unless stated otherwise, any mention of specific securities or investments is for hypothetical and illustrative purposes only. The author’s clients may or may not hold the securities discussed in their portfolios. The author makes no representations that any of the securities discussed have been or will be profitable.
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Key Considerations of Smart Beta Investing originally appeared on usnews.com
