Smart beta – the old/new approach to index tracking

Written by Sally Ling
May 2014

The investment industry is, it seems, almost endlessly creative, constantly looking for new ways to help clients make money, or more recently, in the case of pension schemes, meet their funding objectives. But, one investment approach, around which there is currently a great deal of noise - ‘smart’ or ‘advanced’ beta – is not actually new. While a mostly passive approach to investing in markets, it has its roots in active management and has been gradually building a head of steam since before the 2008 financial crisis.

What has it come from?

In getting to grips with smart beta, it is necessary to understand that it is not a single product nor is it an asset class. Rather the term is used as shorthand to describe a broad range of strategies that aim to capture various characteristics of investment markets. These strategies have been developed in response to dissatisfaction with the traditional passive approach which tracks indices in which companies are weighted by market capitalisation.

As Russell Indexes regional director Jamie Forbes observes: “The market cap index is representative of the market and that has always been its purpose. Traditionally this has been seen as a neutral position. Now the question is, just because it represents the market, does that make it an efficient strategy?”

According to State Street Global Advisors (SSgA) portfolio strategist global equity beta solutions Ana Harris the problem is that people have been disappointed with the performance of market cap index-based funds which are volatile and can be prone to bubbles. But at the same time, they are not happy with the performance of active managers.

So the premises behind smart beta strategies are that investors don’t necessarily want to be exposed to companies simply because of their size, and that by weighting stocks other than by market capitalisation it is possible to achieve a performance difference. This approach borrows from active management, taking some of the factors that have been seen to deliver over the longer term – such as low volatility or low risk – and building them into an index that can be tracked. The result, according to Harris, is an approach which is “more rules based, more transparent, more cost efficient and as such attractive to trustees”. Originally the approach was developed to find ways to outperform market cap indices but as it has developed, the indices have become increasingly specialised and aim to capture specific aspects of a market and manage particular risks. For example a low volatility approach might suit an investor looking for a degree of downside protection and capital preservation.

Harris explains that schemes have been exploring the idea of advanced or smart beta since the financial crisis and that some of the new indices go back as far as 2005/06. But, she says, momentum has increased as more strategies and indices have become available that try to capture the factors and themes behind beta. In short, smart beta has become more visible because there are more opportunities to invest in it.

Issues for trustees

It seems that smart beta strategies have something to offer most pension schemes, but owing to the broad range of approaches available, there is a clear need for trustee education on the topic. As Buck Global Investment Advisors global head of manager research Ciaran Mulligan remarks: “The terminology can be confusing as there are many different strategies that label themselves as smart or advanced beta.” He explains that there are both passive and active approaches to smart beta. While a passive manager will simply track a fundamentally weighted index, more active managers use these indices as a starting point and apply their own additional factors.

So, it is not as simple as trustees deciding to buy into smart beta, rather that the questions that need to be answered are where a fund is now, what it wants to achieve and does smart beta offer the best solution? According to Mulligan, schemes are increasingly adopting a smart beta approach, but it is not necessarily a case of “either/or” as smart beta will perform differently from market cap weighted funds in different market cycles. Instead the approach can add diversification to existing holdings and so could usefully sit alongside passive funds. He continues: “It is important to help trustees understand what the options are, how this approach differs from passive and how different managers approach smart beta.”

One of the oft-cited advantages of smart beta strategies is transparency. Forbes says that Russell believes it is important that smart beta is defined as transparent and rules based – it is important that it can be implemented in a passive way. But, she explains, some strategies are very specific in what they are trying to achieve so it is clear what is contributing to performance. Others are more broad and cover a number of risk factors, and so might be less transparent. Investors need to be aware that not all indices are constructed in the same way. For example, there is no standard approach to achieving low volatility so investors need to understand what goes into the indices.

Mulligan concurs: “It is important that trustees understand what performance is being benchmarked against – to understand the weightings and factors used to develop the index and if and how the manager deviates from this.”

Who is using smart beta?

According to Harris, SSgA’s experience has been that it is mostly larger pension funds that are embracing smart beta. She says that they are more comfortable with the concept than smaller schemes, possibly because they have more internal resources to research these strategies. She has found that the most popular approach with pension schemes is value; most investors are familiar with the concept and there are plenty of passive products available offering this approach. Mulligan, however, believes that the opportunities are not restricted to larger schemes and adds that where pooled smart beta funds are available smaller schemes can access asset classes that might not otherwise be available to them such as commodities or infrastructure.

Does it deliver? Forbes thinks yes: “Generally we tend to hear that investors are comfortable that their strategy is performing as expected.” It is important however that trustees are clear on what they expect or require these strategies to deliver. For example, in terms of absolute performance 2012 was a difficult year for low volatility strategies as we experienced a bull market. But as Forbes explains, they weren’t designed to keep up with equity markets in these circumstances and performed as expected in terms of reducing risk. She adds that these days trustees are less focused on outperforming the market and more on achieving outcomes in terms of risk reduction or diversification that matches their objectives.

Why now?

So, if the problems that smart beta strategies attempt to address have been around since the financial crisis, why is the approach attracting so much attention now? The answer could simply be one of greater supply and opportunity. As Mulligan observes, there are more pooled funds available now offering access across a range of asset classes for small and medium-sized funds.

And the future? The evidence points to the increasing proliferation and uptake of smart beta strategies. According to Forbes, investors are increasingly looking for “more precise” smart beta indices that help them control exposure to factors that affect risk and returns. For example, she says, a low volatility strategy might also have a value bias, but the investor might not want the extra value exposure as they’ve got that covered in another part of their portfolio. So it seems, the strategies available will become more specialised and the opportunities available to pension funds of all sizes will continue to increase.

Sally Ling is a freelance journalist

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