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Why 'smart beta' strategies deserve all the attention and assets they're attracting

Strategies represent a cost-effective way to harnes quantitative insights and quickl, easily implement them in portfolios

Apr 14, 2015 @ 12:01 am

By Dave Donnelly

Debated over whether it is fact, fiction, marketing or all of the above, 'smart beta' has been a growing point of contention in the asset management industry. Based more on the math than the marketing, these strategies are deserving of the attention and assets they are garnering, and advisers would be well-served to consider them. Simply put, they have the ability to generate alpha consistently, with lower costs than alternatives.

The term 'smart beta' refers to the gray area of strategies which aren't quite active management, but aren't indexing, occupy. Smart beta strategies could just as easily be called quantitative strategies, if the word 'quant' hadn't already scared everyone to death in August 2007. The majority of these strategies use the following approach: 1. Start with a widely-held index. 2. Determine via multiple-regression and factor analysis which aspects of the securities in the index tend to identify outperformance. 3. Systematically allocate to the securities with the highest concentration of the good factors and the lowest concentration of the bad factors.

(Related: Read the fine print before plunging into smart beta)

Passive strategists have argued that smart beta strategies can't work, because “if everyone is doing it, there won't be any outperformance available.” While this statement is absolutely true, it is also irrelevant, because everyone isn't going to implement these strategies. The same rule applies for why an increase in the number of indexing investors causes an increase in the amount of available alpha for the active management world. Market inefficiencies are finite, and the more people share in them, the less there is for each individual participant.

ABOUT THE NAME

Was it 'smart beta' when the Fama-French three-factor model described a stock's returns being comprised of its beta, but also of its market capitalization (bias toward small caps) and price-to-book ratio (bias toward value)? Was it 'smart beta' when Cliff Asness showed consistent outperformance by stocks that had demonstrated price momentum?

These well-documented investment analyses, along with many other 'smart beta' strategies, are producing higher returns than their given index without a proportionate increase in volatility. Statistically, those excess returns are referred to as alpha, not smart beta. Jack Bogle is probably right that the term is more marketing than definitional. But for an industry that has been inundated with conflicting messages about the efficacy of active management, new nomenclature that provides a fresh start to outperforming a “buy everything” approach should be welcomed.

(More insight: A deep dive on the rise of smart beta)

The bottom line is that consistent alpha can be generated by focusing on particular permutations of market factors. 'Smart beta' represents a cost-effective way to harness those quantitative insights, and quickly and easily implement them in client portfolios.

NOT PASSIVE

While these strategies can come with a lower price tag than many traditional actively managed funds, the potential alpha they can generate, and the processes they use, are comparable. Many asset managers pride themselves on a repeatable process in their fundamental analysis — 'smart beta' simply takes the repeatable aspect to the next level. Signals and factors that aided bottom-up portfolio managers decades ago can now easily be codified and tested against the universe of investable assets, with an incredible savings in time and manpower, which is largely being passed on to the investor.

As 'smart beta' products proliferate, the opportunities to implement strategies that harness quantitative descriptions of well-documented market inefficiencies become cheaper and more prevalent — all of which is a huge positive for investors.

Dave Donnelly is the founder and CEO of Strategic Alpha, a rebalancing service dedicated to helping advisers improve client outcomes.

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