Smart Beta: its risks and returns


Tuesday, December 3, 2019 | By Zenil Shah, Senior Associate, Regulatory Solutions

Smart Beta: its risks and returns

Investment strategies can be an Active Investment (obtaining Alpha) or Passing Investment (Replicating Index or Benchmark).

Active Investments:

  • Attempt to beat the market or Passive Investment (Benchmark/Index) by taking advantage of short-term volatility in the market to obtain Alpha.
  • An active fund manager may give investors access to products that the average person cannot obtain.

Passive Investments:

  • Tracks a market Index or a replica of a Benchmark/Index.
  • Suitable for long-term investors and risk-averse investors
  • Fewer products are available to investors

Smart Beta is a combination of value investing and efficient-market hypothesis. Smart Beta investing combines the benefits of Active Investing and Passive Investing strategies to obtain Alpha, lower risk or increase diversification at a lower cost than active management, and at a slightly higher cost than direct Index investing.

"Smart" refers to the use of an alternative methodology rather than following an Index's size-based (market-cap) allocations. Smart Beta seeks to passively follow indices, while also taking into account alternative weighting factors such as:

  1. Volatility: High-volatility stocks have lower returns than low-volatility stocks; volatility doesn’t increase in value of stock when the market is bullish. Volatility can be leveraged to maximize returns from below-average and low-volatility stocks, or Beta.
  2. Liquidity: Market capitalization and size are highly correlated with liquidity; consequently, a slope towards small-capitalization stocks also establishes itself as exposure to relatively illiquid stocks.
  3. Quality: Good quality stocks have sustainable profits over time and have strong fundamentals for good returns. It’s a good strategy to find companies with strong and stable revenue or earnings, as well as low debt.
  4. Value: When a company’s stock is undervalued in the market despite strong and stable earnings are considered as valued stocks, when such stocks are overlooked by other investors.  Correct interpretation of a stock’s value can maximize returns from stocks priced below their fundamental value.
  5. Size: Stocks are measured by free-float market capitalization and divided into large-cap, mid-cap and small-cap. Some of the highest returns can come from small-cap and mid-cap.
  6. Momentum: Bullish or bearish momentum tends to trend for some time; strong past performance is a good indicator of future potential to maximize returns.
  7. Yield: High-dividend-paying stocks often appear undervalued. Returns can be maximized by identifying stable stocks with increasing dividends.

Famed investor Michael Burry, who predicted the housing crisis, sees Passive Investment as a “bubble.” He told Bloomberg, “The bubble in Passive Investing through ETFs and Index funds as well as the trend to very large size among asset managers has orphaned smaller value-type securities globally.”  

The risk associated with Index funds is that they tend to be heavily weighted towards stocks or sectors that are performing great during a booming period. When bubbles burst these Smart Beta strategies can offer a degree of protection against this and other investment risks. Hence, Smart Beta investment strategies can help to enhance portfolio returns with reduced portfolio risk, and also offer more accurate equity risk premiums. In addition, Smart Beta can be used for risk management

A downside of Smart Beta investing is an increase in expense ratio when compared to traditional Passive Investments, due to portfolio turnover and rebalancing costs. An extended period of underperformance shows that Smart Beta funds have failed to fulfill investor expectations over the past decade.

Some anomalies indicate that the more people use these factor models (Smart Beta strategies), the less you can extend extra return from those risk factors. The same can be said for value investing. In the past, it was easy to identify undervalued asset/stock and buy it. Now, faster communication channels for all fundamental information published online, everyone knows to buy undervalue assets, so they don’t stay undervalued for long.

Smart Beta has been growing with Passive Investing for a long time, and has also become a driving force for superior long-term performance metrics.

 

Reference:

https://www.quantilia.com/smart-alpha-strategy/

https://www.businessinsider.in/big-short-investor-michael-burry-predicted-the-housing-crisis-now-hes-calling-passive-investment-a-bubble-/articleshow/70882640.cms

https://www.ftse.com/products/downloads/Factor-exposures-of-smart-beta-indexes.pdf

https://www.betterment.com/resources/smart-beta-portfolio-strategy/

https://www.investopedia.com/terms/s/smart-beta.asp

https://www.cnbc.com/2016/01/19/10-things-investors-need-to-know-about-smart-beta.html



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