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August 27, 2015 at 08:00 PM
The active-versus-passive investing debate has prompted exploration of “smart beta,” which moves away from traditional market capitalization in constructing allocations. Some advisors question whether the traditional approach still holds value.
A more appropriate consideration is to evaluate the client’s allocation needs, risk tolerance and investing goals, asking:
- What is the best way to meet the client’s needs?
- Which tools can most effectively do so?
- How do those tools fit into the overall allocation model?
- Do those tools carry unintended biases and risks that could compromise the portfolio?
TRADITIONAL BETA’S ADVANTAGES
Traditional beta provides:
- a legacy representation of the overall market;
- low tracking error to its respective market;
- ease of maintenance and rebalancing;
- ease of trading and reconstitution; and
- greater product capacity.
Used correctly, factors can enhance risk management and diversification within a portfolio, offering opportunities to better enhance risk-adjusted returns than market-cap- weighted indices. Market-weighted approaches can work in tandem with factors to better achieve client goals.
WHERE DOES SMART BETA COME FROM?
Smart beta builds on William Sharpe’s capital asset pricing model (CAPM), where
Expected return = risk-free rate + market beta * market premium.
This accounts for 70% – 75% of returns.
Eugene Fama and Ken French’s model considers three factors:
- Volatility
- Size – exposure to small-cap stocks, expressed as small minus big (SMB)
- Value – high-value, or low price-to-book stocks, minus low-value or high price-to-book stocks. These also are called growth stocks and are expressed as high minus low (HML)
The three-factor model accounts for 90% of returns. That’s a big change from the traditional CAPM, which put managers’ alpha – their ability to beat the market – at 25% – 30%. Adding in the size risk premium and the value risk premium reduced managers’ alpha to 10%.
A fourth (Carhart) model added momentum, accounting for 95% of an investment’s return and reducing managers to just 5%.
Market-weighted products tend to be overweight in large-cap and growth names. Smart beta can potentially provide a neutral portfolio with market exposure as well as neutral exposure to other factors such as size and value. But smart beta has been reinterpreted to cover anything not market cap-weighted, which dilutes the true academic definition.
Instead of focusing on the label, it is more effective to understand the factors behind the concept. A lot of the most popular smart beta strategies take advantage of factors defined by academic research. Fundamentally weighted indices and dividend-weighted indices, for instance, both correspond to the value factor. Equally weighted indices offer exposure to size. Quality indices often focus on profitability. And 0–5-year bond indices manage exposure to term, a fixed-income factor.
Fund flows over the last several years reflect strong interest in nontraditionally weighted indices in the wake of post-crisis de-risking. Factor investing gives people a way to get incremental exposures in their portfolios. Factors also allow investors to increase diversification despite closer correlation of U.S., international and even emerging markets.
Investors looking solely at markets lose opportunities for diversification that factors provide. For instance, size can provide diversification if small caps in the United States are underperforming while they’re outperforming in emerging markets. Another point: factors must be viewed globally, not just in the United States.
HOW ETFS HELP
