Determining whether these ideas have a place in client portfolios, and how to adjust allocations to take advantage of them.
There's no question that smart beta strategies have captured headlines as well as the attention of investors and advisers, but do they have a place in your clients' portfolios? And, more importantly, how might you adjust your asset allocation models to capture the benefits of these strategies for clients with different investment needs and goals?
The first generation of exchange-traded funds was designed to mimic popular market-cap indexes, providing cost-effective exposure to virtually every segment of the equity market. In the last several years, we have seen a proliferation of smart beta strategies designed to improve the market experience while still using an index-based approach.
Smart beta — also known as “strategic beta” or “alternative beta” — includes such non-capitalization-weighted strategies as equal weight, low volatility and fundamental strategies. While all of these fall under the smart beta umbrella, there is a high degree of variability across the strategies, largely due to the differences in the screening and weighting methodologies of the underlying indexes.
It's important that investors understand the different sector allocations, market capitalizations and value-growth tilts of these strategies before making any investment decisions, particularly as the strategies gain popularity. Morningstar Inc. categorizes these strategies as strategic beta and estimates that there were 374 such exchange-traded products with roughly $400 billion in assets under management as of Dec. 31, 2014, up 22% over the prior year.
We view these strategies as being on a continuum between traditional market-cap indexes and active management because they capture many of the positive attributes of both.
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BUILDING BETTER PORTFOLIOS
Market-cap, fundamental and active management strategies can each have a role in a portfolio.
• Market-cap strategies provide cost-effective exposure to a broad market or market segment: Most major indexes are market-cap weighted — that is, stock weights are calculated by multiplying the price of each stock by its number of shares outstanding, which means the largest company by market capitalization has the largest weight in the index.
• Active management can potentially help protect on the downside: Active managers generally seek to outperform their benchmark. There is a lot of research showing how difficult it is for active managers to consistently outperform their benchmarks over time, particularly after accounting for fees. However, active managers have greater flexibility and adaptability in responding to changing market conditions and may be able to limit losses.
• Fundamental strategies can potentially generate excess returns: When it comes to the smart beta slice of the portfolio, we have focused on fundamental strategies because of their strong absolute and relative results compared to traditional market-cap indexes and many actively managed funds. Like market-cap strategies, fundamental strategies can provide broad-based market exposure, but securities are selected and weighted based on financial metrics that assess some aspect of a company's overall financial health, such as earnings, sales or dividends.
APPLYING IT TO YOUR ASSET ALLOCATION MODEL
We have developed a framework for allocating among market-cap, fundamental and active management by thinking about four different levers: tracking error, loss aversion, potential alpha (excess return) and costs. Depending on your clients' sensitivity to the four levers, you might overweight or underweight your allocation to fundamental strategies, market-cap strategies and active management.
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Keep the following in mind when thinking about how each strategy potentially performs across these four levers:
• Market-cap strategies generally experience little or no tracking error, although fees could cause a small drag. However, they do not offer the potential for either downside protection or alpha.
• Fundamental strategies provide cost-effective exposure to the markets and have the potential for alpha over a full market cycle. There are periods of time when fundamental strategies will outperform or underperform the market. They have a higher tracking error than market-cap strategies and do not offer the potential for downside protection.
• Active strategies, which can have higher fees, have the potential to provide alpha and/or a degree of downside protection over time. They have greater flexibility to adjust their strategies in difficult markets and can become more defensive, based on their market outlook.
Portfolio construction should incorporate elements of art and science. Advisers can't lose sight of clients' individual needs and risk tolerance. So keep in mind the four levers — tracking error, loss aversion, potential alpha and costs — and clients' sensitivity to them when building portfolios.
Anthony B. Davidow is vice president for alternative beta and asset allocation strategist at Schwab Center for Financial Research.
