Smart beta strategies: Outsmarting the market?

Traditionally, investors had two choices – track stock markets by buying low-cost index funds, or opt for more expensive active funds that try to beat market indices. Now, however, investors are increasingly opting for a hybrid approach, aiming to achieve market-beating returns in a low-cost, index-like manner.

Advocates of so-called smart beta strategies say they aim to combine the best elements of active and passive investing. The jargon may be off-putting – Nobel economist William Sharpe says talk of smart beta makes him "definitionally sick" – but the basic idea is a simple one: to improve on index funds.

The S&P 500, the FTSE 100, the Iseq and most mainstream indices are weighted by market capitalisation, with the largest companies having the biggest weight in the index. Apple, the most valuable company in the world, accounts for almost 4 per cent of the S&P 500; the top 5 holdings in the FTSE 100 (HSBC, Shell, BP, GlaxoSmithKline, and British American Tobacco) account for 24 per cent of the index; CRH alone accounts for 23 per cent of the Iseq. Critics say cap-weighted indices run the risk of significant declines if a handful of constituent stocks tumble. Furthermore, they say that tracker funds are dumb, in that they will end up being too invested in overpriced stocks, and too little in underpriced stocks.

Alternative

The alternative is to tweak how indices are constructed, so more stocks are bought when they are undervalued. This may be done by weighing indices by different measures such as dividends, volatility, valuation or simply by taking an equal-weighted approach. An equal-weighted version of the S&P 500, for example, would result in each of its 500 stocks accounting for 0.2 per cent of the index, rather than being dominated by larger companies like Apple and

Exxon Mobil

.

Enthusiasm towards alternative indices has grown since Rob Arnott of Research Affiliates, the firm most associated with smart beta products, published a paper on the subject in 2004. Arnott claimed that indices based on factors other than market value had beaten the market by more than 2 percentage points per year over the previous four decades.

More recently, S&P Dow Jones Indices noted that an equal-weighted S&P 500 would have achieved annualised returns of 9.1 per cent over the last 15 years, compared with just 4.5 per cent for the cap-weighted S&P 500. The same report found equal-weighted indices would have outperformed for 10 of the last 13 years in both the US and Europe. In the UK, too, the results are promising; according to FTSE, an equally weighted FTSE 100 would have returned 138 per cent between 2001 and 2014, compared with total returns of 93 per cent for the cap-weighted FTSE 100. Over the same period, active fund managers have badly underperformed. Growing frustration with this perennial underperformance has led to money flowing into smart beta funds in recent years.

According to US research firm Morningstar, $544 billion (€477bn) is now invested in smart beta funds, a five-fold increase since 2008. A Cogent Research report last year found that a quarter of institutional investors are now using exchange-traded funds (ETFs) based on smart beta strategies. Among those who don't yet do so, almost half plan on investing in the area in coming years. Growing demand has resulted in a plethora of smart beta ETFs being launched – Morningstar says 345 such ETFs are now on the market.

Smart marketing?

However, many investors remain wary, and say smart beta is little more than smart marketing. As mentioned earlier, the term makes William Sharpe “definitionally sick”; Vanguard’s John Bogle, founder of the world’s first index fund, describes the practice as “witchcraft”; other indexing gurus like Nobel economist

Eugene Fama

and bestselling author

Burton Malkiel

are similarly sceptical.

Why? Firstly, there is the issue of language; labelling alternative indices as smart indicates that market-cap weighted indices are dumb. However, different strategies work better in different cycles, and even so-called smart strategies can underperform for many years, as was the case for much of the 1990s.

Similarly, critics say there is nothing new about this approach. For decades, academics have known that investing in small-cap and value stocks has delivered better returns, and specialised index funds have long been available to investors looking to invest in these areas.

Smart beta products, they say, ultimately differ little to small-cap and mid-cap index funds.

There is one key difference, however – annual fees tend to be higher with smart beta products. Equally-weighted indices, for example, tend to be rebalanced quarterly, so that rising and declining stocks retain their identical weighting, meaning fees will inevitably be greater than in conventional passive funds.

There is also the possibility of more volatility. Small-cap and mid-cap stocks tend to be more volatile than their large-cap brethren. Equal-weighted funds, by tilting away from the biggest names, increase investors’ exposure to smaller, more volatile names.

Additionally, there is the argument that smart beta funds are an attempt to profit from various market anomalies, such as the tendency for cheap and small-cap stocks to outperform. However, market anomalies often disappear when they become widely known; if more money begins to chase such stocks, the performance differential may be eroded away.

Rebalancing

Advocates say smart beta is more than about having exposure to small-cap and value stocks. Rather, they argue there is an inherent benefit to the simple practice of rebalancing. A 2012 study,

Why does an equal-weighted portfolio outperform value- and price-weighted portfolios?

, suggests this is indeed key.

The study looked at equal-weighted portfolios that are rebalanced at different intervals. Portfolios rebalanced once a year outperformed by 0.8 per cent annually, compared with 1.17 per cent for those rebalanced on a six-monthly basis, and 1.75 per cent for funds that were rebalanced once a month.

In other words, outperformance arose “not from the choice of equal weights, but from the monthly rebalancing to maintain equal weights”.

Rebalancing means selling winners and buying losers, an “implicitly contrarian” strategy that more often than not delivers the goods.

Questions

Questions remain regarding the marketing and terminology surrounding smart beta products, and advocates of a truly passive approach are likely to remain sceptical of any strategy that promises market outperformance.

However, it’s clear why institutional investors favouring an evidence-based, active approach might be tempted. Conventional active funds are expensive, and their high fees invariably hobble their odds of outperformance.

Additionally, it is difficult, perhaps impossible, to spot skilled managers in advance, as past performance gives little clue of future returns. Indeed, even if you do invest with a skilled manager, he or she may well move on to pastures new – after all, fewer than a fifth of UK fund managers have managed their portfolio for 10 years, while roughly a third have been at the helm for less than three years.

That contrasts with what Research Affiliates calls the “rules-based, transparent, low-cost approach” of smart beta products. The increased popularity of low-cost strategies, coupled with frustration regarding active managers’ habitual underperformance, means the migration to smart beta funds is likely to continue for some time to come.