By Mike LaBella, Portfolio Manager at QS Investors
Names Do Not Matter
Smart beta means many things to many people. Defining characteristics typically include investment strategies that are simple, transparent and rules-based. Many names are used: factor investing, anti-benchmark, strategic beta, advanced beta, scientific beta, alternative beta, enhanced indexes, quantamental indexes, quasi-active, alternative-weighted, anti-beta… Yet few of these names are actually descriptive of the resulting investment outcome, which vary widely due to the starkly different approaches employed by these strategies.
Outcomes Do Matter
The best way to show how smart beta works is to start at the end. Generally, smart beta ETFs are intended to achieve two investment outcomes: core exposure (style neutral and broadly diversified) and style investing (value, momentum or defensive). They can reduce exposure to volatility, reap unrecognized potential that investors tend to ignore, take advantage of market trends by riding waves of positive sentiment, or offer efficient ways to capture upside potential. All can be designed to work in specific market environments, which may underweight a short-term opportunity for the benefit of the long-term strategy. Buying smart beta means investing in outcomes.
Human Behavior Impacts
The return premiums expected from smart beta are grounded in investor biases which are systematic in nature, as opposed to unsystematic misjudgments of a stock’s fair value. Understanding why illuminates when smart beta can perform best. Over the long term, value stocks have outperformed growth stocks. Some explain this as the result of overly-confident investors too optimistically extrapolating companies’ growth prospects. Defensive stocks have historically outperformed the market on a risk-adjusted basis, which may result from investors being drawn to stocks with lottery-like pay-offs. This would cause growth and risky stocks to be over-represented in capitalization-weighted indices, which are usually – predictably – on the “wrong side” of behavioral biases.
Diversification Requires Effort
Excessive enthusiasm for fashionable market segments is not the only cause of poorly diversified indices; U.S. stocks often are over-represented in capitalization-weighted indices, despite their share of the world economy. Over a century ago, railway companies accounted for over 60 percent of the value of the U.S. stock market; today, they are less than 1 percent1. More recently, Microsoft’s (NASDAQ:MSFT) dominance of the tech industry appeared unassailable. With few “sure things,” diversification can offer efficient ways to capture equity opportunities, if investors can avoid taking on unintended bets born from the capital market structure. When using multiple strategies, investors should determine which add diversification, and which pile on the same return and risk types they already have in their portfolios.
For the Long Term
Markets can reward and penalize any investment process at any time. But over a full cycle, many smart beta strategies outperform. Investors may be especially keen toward those that offer performance when investors need it most – under large market drawdowns. The performance of smart beta ETFs focused on diversification or targeted investment styles will vary significantly across market regimes. Those that provide greater diversification typically work to buffer the downside like most other well-diversified investments.
A Piece of the Puzzle
When implemented well, smart beta ETFs can tactically enhance overall portfolio performance while providing real diversification. They should be used to achieve specific, targeted investment goals.
Smart Beta is Here to Stay
Smart beta is succeeding because it largely works, in a variety of ways. Understanding how particular approaches perform in various markets can lead to a better understanding of outcomes, which can allow investors to select options that best suit their needs. Only then can investors be smart about smart beta.
Previously published in ETF Trends on April 19, 2017
All investments involve risk including possible loss of principal
The views expressed are those of the portfolio managers as of the date indicated, are subject to change, and may differ from the views of other portfolio managers or the firm as a whole. These opinions are not intended to be a forecast of future events, a guarantee of future results, or investment advice.
Diversification does not guarantee a profit or protect against a loss.
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- Source: Credit Suisse Global Investment Returns Yearbook, 2015.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.