Using smart beta in an outcomes-oriented portfolio

It’s no secret that the active versus passive debate is not black and white. There are many flavors of both active and passive management, and thus the supposed competition between the two — as often framed by pundits — is a tad simplistic. Before selecting any investment strategy, advisers would be better served by determining what each portfolio is lacking or what can benefit it.

In other words, advisers should start by solving for an outcome and then select the best strategy for the job, based on the client’s defined objective or the inherent limitations of an existing portfolio. In many cases, there is room in an outcomes-oriented portfolio for both passive and specialized active strategies, as well as some potentially promising approaches that bridge the gap between the two.

One blended approach that continues to gain momentum is strategic beta. Often called smart beta, strategic beta refers to a group of indexes and related investment products that aim to provide an alternative to the traditional market-cap weighting strategies of passive investments while trying to preserve the return/outcome enhancement and risk mitigation of active strategies. On the active-passive spectrum, we think of strategic beta as more of an active solution because it can be used to address a variety of investor challenges. However, it is grounded in rules that can be vetted by history and academic theory in different market environments. This type of rules-based strategy may offer the potential for attractive returns and reduce risk at lower relative costs.

(More: Smart-beta ETFs take in billions in new assets)

THREE LEGS OF A STOOL

Within the active versus passive portfolio debate, advisers typically focus on three critical elements for their clients: return, risk and cost. With return, more is better, and with risk and cost, less is more. Strategic beta seeks to provide a disciplined, active-like approach to indexing in a cost-effective manner, and thus provides an adviser with the tools needed to balance the three legs of the stool.

The potential combination of more returns, less risk and lower costs is the lure of strategic beta and the reason for its soaring popularity. These strategies seek to enhance a passive allocation and counterbalance some of the inherent biases and other limitations of cap-weighted indexing, while striving to deliver alpha at lower costs than active strategies.

The universe of smart beta products is growing rapidly and now covers such a diverse array of investment philosophies that investors need to understand the underlying rules and approach used by each strategic beta index and corresponding product prior to any allocation decision. Advisers should expect most strategic beta solutions to cost a bit more than the few basis points the largest passive funds charge. On the other hand, smart beta products also should be more cost-effective than active approaches that endeavor to deliver alpha. This is why potential net-of-fee outcomes are important to consider.

WHEN TO DEPLOY STRATEGIC BETA

Active management still seems to make sense in in the less efficient or niche areas of the equity market, where managers can exploit information inequalities and otherwise leverage their skill. However, in some highly liquid, large-cap market sectors, it’s becoming increasingly difficult to consistently outperform popular benchmarks, to say nothing of convincing investors that they should deploy their fee and risk budgets to such active strategies.

Before incorporating any strategic beta products into a client’s portfolio, advisers must have a clear understanding of the challenges at hand and the desired outcome for each portfolio. Bypassing this critical first step and arbitrarily trying to fill an allocation bucket with random strategic beta funds or focusing too much on past performance alone can have unwanted ramifications. Such a short-sighted approach could skew the portfolio with sector biases or inadvertently double down on unintended factor exposures. The result could be a drag on the overall portfolio or movement away from the desired goals.

Advisers should look within to determine whether the potential benefits of strategic beta are in alignment with their clients’ investment goals. They should consider how a smart beta allocation might impact the overall risk profile of their portfolio. Will the strategy improve diversification and lower correlations between strategies for the entire portfolio? Will it help achieve the outcome the client desires? Will it allow me to spend more of my risk and fee budget elsewhere in the more inefficient areas of the market?

Finally, when evaluating strategies, it is critical to compare them on a relative, risk-adjusted basis, rather than on absolute performance. Relative is the key word when contemplating strategic beta’s costs, risks, and return potential. Following this principle can help advisers incorporate strategic beta products more effectively — and build more resilient, outcome-oriented portfolios for clients.

(More: Smart-beta funds get mixed reviews in the first quarter)

Mannik S. Dhillon is president of VictoryShares and Solutions.