What Makes Smart Beta Smart


By Fazila Manjoo
Head of Research at STANLIB Index Investments

What is smart about smart beta is that it seeks to outperform market capitalisation-weighted indices over the long term. While beta funds, commonly called index tracker funds, provide exposure to market risk, smart beta funds move away from market capitalisation to selecting and/or weighting shares according to risk factors that have proven to outperform the market over time.

Smart beta funds, also called factor funds, offer investors the opportunity to invest in a particular style or theme they find attractive, for example value and momentum. The systematic and rule-based approach ensures that clients gain consistent and reliable exposure to the factors they desire, at a low cost.

Diversification by Risk Factor

It is important to understand that while smart beta funds, have the potential to outperform the market index over the long-term; it can underperform over the short-term. The value effect, that is the tendency of value stocks to outperform the market in the long-term, has been observed for decades. Value stocks can however underperform markets significantly for a period of time, for example during a bull market. Similarly stocks with momentum perform fantastically, but can sometimes crash.

The performance of individual factor strategies is cyclical. To reduce sensitivity to cyclical performance, investors can use smart beta funds to combine several factors and create a diversified multi-factor portfolio. A very simple construction example would be to equally weight uncorrelated factor funds, like value and momentum and this is illustrated in the chart below.

 

Chart 1: Calendar year returns in South Africa of a simple Multi-Factor portfolio
with 50% in Value and 50% in Momentum, versus Value, Momentum and the Market

 

Source: STANLIB Quantitative Investment Strategies. Total returns in ZAR were independently calculated by S&P, using the S&P South Africa Composite Index, the STANLIB Sector Neutral Momentum Index and the STANLIB Sector Neutral Value Index.

 

Over time some factors will perform better than others, and investors can take advantage of factors’ cyclicality by using periodic rebalancing to take profits. More sophisticated investors can consider prevailing market conditions and enhance returns by dynamically change their allocations to risk factors through time.

Smart beta funds can also be used to hedge unintended risks in a portfolio. Investments in both active and passive funds can sometimes result in exposure to unintended risk and investors can use smart beta strategies that offer cost effective diversification to reduce this risk.

Many investors criticise index tracker funds for being concentrated in the largest market capitalisation shares, arguing that weighting a portfolio in this manner does not take cognisance of the valuation of shares. This can lead to more expensive stocks having a much larger weighting than cheap stocks – as we have seen with Naspers in the FTSE/JSE Shareholder Weighted All Share index. Holders of index tracking funds can diversify unintended risks by allocating to uncorrelated smart beta funds.

Investors in active funds can also minimise unintended risks. For example, if an investor is allocated to a fund with a strong value bias, the investor can allocate a portion of assets in smart beta funds that are uncorrelated to value, like a momentum fund, and therefore reduce the negative consequences of value underperforming.

Investors can therefore use smart beta strategies as building blocks to construct diversified multi-factor portfolios that offer ‘active-like’ returns for ‘passive-like’ fees. These solutions have the benefits of passive investments i.e. simplicity, transparent construction, diversification and low fees, with the opportunity for investors to achieve excess returns.


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