Smart-beta strategies can help today’s investors, but they’re not all created equal

This is hardly news to a financial adviser audience, but investor needs are diverging. Large demographic shifts toward retirement are creating increased demand for secure income while future obligations are skyrocketing for the young (college and health care, chiefly).

All this while financial markets grow more complicated. The volatility which has plagued the market continues, with fears over the yen, oil, and the state of economic growth in China. Fixed income rates are rising, finally — but from zero. A very cautious U.S. Federal Reserve may take years to achieve a normalized rate environment.

There continues to be growing concern about the sustainability of the recovery and the possibility of a global recession.

There is likely to be little “easy money” in the markets that investors can depend on in the short-term. We are all going to have to brace for lower returns.

(Related read: How to handle return-hungry clients’ portfolios during upticks in volatility)

Thus we must rethink our approaches. True diversification has perhaps never been more important, but it doesn’t start and end with a diversified asset allocation model. The unfortunate truth is that most investors don’t realize the concentration risk they have in market-cap-weighted products where more than half of the investment can be in just two countries or sectors.

What investors need most now are not products, but solutions — investment strategies focused on what they want to achieve. So where should we be leading investors?

There are many names under the “smart beta” solutions umbrella, which can be confusing. Their shared goal is to offer alternative approaches to familiar investment challenges, aiming to achieve some up-market capture, with the potential to manage risks on the downside.

Whether to manage market volatility, deal with currency risk or gain exposure to fundamental characteristics like value stocks, smart-beta strategies can offer focused solutions investors want and need. All are not created equal, however. It is incumbent on asset managers and advisers to explain their features and potential benefits to investors.

Smart beta has become the next new thing, the financial media darling, yet investors would do well to look deeper and perform substantial due diligence when considering these investments.

Costs matter, but understanding and being philosophically aligned with a particular product is important. Did the strategy perform as expected in periods of distress?

Based on weightings other than market capitalization, smart beta solutions are growing in popularity because they seek to solve genuine problems. These strategies seek to identify biases in the market and either mitigate or take advantage of them. It may sound simple, but it’s not.

Think about the number of investors who believe market-cap-weighted exchange-traded funds (ETFs) are “diversified.” In the sense that they hold lots of names, they are, but nowhere near as much as some may think.

Smart beta attempts to address these problems, at a lower cost than traditional actively managed products. It does so by pursuing rules-based approaches that are periodically rebalanced to reflect changing market conditions.

(More insight: Why this could be the year of multifactor ETFs)

The number and types of smart beta products have mushroomed in recent years. While choice can be a positive, it can also leave investors with a bewildering array of offerings that defy straightforward apples-to-apples comparisons. But analysis based on outcomes can reveal telling distinctions.

The vast majority of smart-beta approaches are biased to a particular investment style. Understanding how these styles may behave in different market environments is critical to crafting the desired outcome. Many can be characterized as “defensive,” seeking to provide investors with risk management from certain types of market conditions by looking to limit downside risks. This is a key reason smart-beta strategies are becoming more popular, with equity-market risks increasing.

For example, value strategies focused on buying out-of-favor companies may introduce volatility but, depending on market conditions, can enhance returns. Multi-factor strategies have become increasingly popular, but while they are often positioned as core allocations, their screening processes can have a bias away from growth stocks. Contrast this with core strategies that seek to diversify across the key drivers of risk in the market — namely macro exposures like country and sector. These strategies do not have a clear factor bias, and may be more applicable for investors seeking true diversification with smoother return potential.

What we should bring home to clients with varying goals is how they can each potentially take advantage of the many different smart=beta strategies – and their many outcomes. There is no one-size-fits-all strategy. Do they want volatility management? A better core? Are they trying to potentially take advantage of a market trend? The possibilities can be tailored to investors’ specific portfolio needs.

Pursuing smart-beta solutions can help savvy investors achieve their goals, short-term and long. They may require a little more explanation, but if they can deliver what investors want and need in these increasingly insecure times, the time and effort will be well worth it — on both sides.

Rick Genoni is head of ETF product management at Legg Mason.