The third way

There has been a growing body of research to show that the hypothesis that market cap weighting was efficient as an investment strategy was in actual fact not true. Last year researchers at Cass Business School found that equity indices constructed randomly by monkeys would have produced higher risk-adjusted returns than an equivalent market cap-weighted index over the last 40 years.

“In market cap weighted portfolio you are buying more and more stocks as they get expensive. That is the opposite of a winning investment approach,” explains Russell Indexes regional director Jamie Forbes. “So if you can be more clever than adopting market cap strategy in a passive rules-based way, for example tilting towards value stocks, you have a better chance of outperforming the market over time.”

The market cap index, she adds, still has to be the barometer of what the neutral position is because everything else will have periods of underperformance, namely periods where the market is being driven by sentiment or momentum.

Since the mid 1980s the ‘Russell 2000’ was the first index to capture the small caps, followed a few years later by the value and growth styles through market cap indices. “Today our ability to capture smart beta has improved,” offers Forbes. “The advent of ETFs and passive investing and tracking an index has evolved to other forms of indices.”

Russell takes a broad view in defining smart beta. It calls it a “transparent rules-based way to capture market exposures or factors”. A market exposure might be small cap companies or value companies. Other types of factors might be quality or momentum or low volatility. There are also strategy-based smart beta approaches, which are alternative ways of weighting the market. One widely-followed approach is a ‘fundamental’ weighted index, which weights stocks by something other than price, namely cash flow, dividends and sales.

“We are seeing an increasing diversification between active, passive and smart beta, which has to be aligned with investor objectives such as risk constraints, time horizons and investment appetite,” says Forbes. “For example, an active manager could take our smart beta indices and apply judgment about how they would apply weight or timing to the overall portfolio.”

There has been a lot of development of smart beta within the equity side of a portfolio. Forbes might see 20-30 per cent in smart beta, and the remainder benchmarked to cap weight, with a mix of both active and passive strategies.

Smart beta has become a topic on the agenda for investors, notes Towers Watson’s investment consultant in the manager research team, James Price. He says it offers a way for investors to access exposure previously only available through an active manager. But he warns that the range of smart beta offerings is extensive and can be very complicated and so asset owners really need to understand how suitable each strategy is for them.


He says there are three main advantages to employing smart beta. They are simplifying part of a portfolio, cost reduction and portfolio construction.

Smart beta can help simplify parts of the portfolio to diversify or allow operational ease – for example, an asset owner may have a number of active managers with a value bias for selecting stocks. It might be that they are at a stage of wanting to de-risk and therefore looking to sell their equity portfolio in the future. If they have five or six active managers then that can be a complicated process. In order to simplify the process an asset owner can change from using active managers to using one or two smart beta strategies. On the other hand, they may wish to invest in new diversifying asset classes such as commodities or reinsurance. Again smart beta can be used to free up time to invest in new asset classes.

It can also help with cost reduction, for instance if a portfolio has expensive active managers, then smart beta can be used to retain an overall value bias, while reducing costs.

Smart beta also aids portfolio construction as it offers investors a way to really think about what underlying risks and factors may drive their portfolio. It is a useful, additional lens to look at the diversification of the portfolio.

Price does not believe in prescribing a particular allocation to smart beta as it depends on the investors’ objectives. “Our view is that it is a tool, an excellent addition to an investor’s tool box. But you have to use it for the right job and you have to be very careful about using it appropriately. It is not right for every asset owner but if it is right we will make use of it.”

“Investors are looking for an investment that will achieve a better risk adjusted return, or in the case of minimum volatility, less risk per unit of return,” says index provider MSCI managing director Brett Hammond. “They are looking for it in a systematic way rather than relying on the vagaries of active management.”
He says that investors are typically taking between 30-100 per cent of the equity portfolio and putting it in one or more of the indices – which often are minimum volatility, value and quality.

Looking at the statistics from 1988 to present – the MSCI quality index has returned 60 per cent more than the market-cap weighted world index. In contrast the minimum volatility index has returned 10-15 per cent more. Hammond explains that the volatility index is not designed to give super returns but to dampen volatility. By combining the two indices, he says, you get “a superior combination of risk and return”.

Increasing attention

Russell’s March 2014 survey of asset owner’s perceptions of smart beta across North America, Europe and Middle East, showed that smart beta is attracting a lot of attention. Two thirds of asset owner’s evaluating smart beta said they expect to make an allocation in the next 12-18 months. Larger asset owners were comfortable putting more in smart beta whereas smaller investors were just “dipping their toe” (less than 10 per cent allocation) but indicated that they would increase over time.

Towers Watson has seen a surge in smart beta allocations. Its clients made over twice as many new investments in smart beta strategies during 2013 alone - around $11 billion across approximately 180 portfolios. This compares to the approximate $5 billion invested across almost 130 portfolios the year before.

Towers Watson global head of investment research Craig Baker says it had taken some time to get to this point, given that it started developing the concept in 2000 as part of its work on structured alpha, and then in more detail in 2002 as beta prime.

Hammond says that in Europe, Danish, French and Dutch pensions in particular have shown interest in smart beta, with Swedish Pension Scheme AP4 and French Pension Scheme FRR having allocations to the MSCI factor indices.

But it is still early days and he expects the market to grow from strength to strength. “There is a revolution going on in investing. For so many years we had just active and passive and then smart beta comes along. “Investors can access returns that used to only be accessible to active managers and they can now do it passively. It’s a third way.”

Written by Nadine Wojakovski, a freelance journalist

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