Investment Product Review


In this series we examine investment products and strategies, from the mundane to the highly complex, explaining how they work and why we do or do not use these particular products or strategies in our portfolios.

Smart Beta: The Future Of Investing Or Another Sales Tactic?

The passive versus active investment management debate continues to rage on, although the recent momentum appears to be on the side of passive managers promoting index linked funds.   In fact, equity index funds now comprise 21% of the equity mutual fund universe (as of the first quarter of 2013), up significantly from 12% in 2004.1  This inflow of assets into index funds has led to fierce competition among fund providers.  Since these funds track specific indices, and are designed to achieve allocations identical to the chosen index, the primary method of competition among funds is price (via the management expense).  As prices have been driven down to near the minimums required to cover expenses, to attract investors, fund managers have strong incentives to explore other options to differentiate their products.  This has led to an explosion of “smart beta” products — the topic of this Investment Product Review.

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Smart beta investment products, as used here, means strategies that are inexpensive, transparent, and systematic, but that diverge from the traditional market cap-weighted indexes, such as the S&P 500 or Russell 1000.  The “beta” in smart beta refers to capturing the risk-adjusted return from the market, as opposed to “alpha”, or return not due to known market risk factors.  This approach lends itself to indexing or index-like strategies, so many of these funds are based on customized indexes, which in many cases are created specifically for each fund.  (While there are some non-systematic funds that claim to provide smart beta, these funds tend to be active funds in disguise, and for clarity, should not be included in this category.)

Of the funds that follow systematic strategies, there are a variety of methods favored by portfolio managers.  Many of these strategies focus on well established market factors like size and value.  Briefly, a long-term return premium has been shown with small cap stocks and value stocks (stocks with low price-to-earnings or price-to-book value ratios). These factors can in fact explain any perceived outperformance by many smart beta funds.  For example, a simple strategy employed by these funds is the equal weighting of every stock in an index.  For example, the fund could take every stock in the S&P 500 and assign a 1/500th weight (or 0.2%) to each stock, as opposed to weighting each stock by its relative market capitalization as is the case in the index.  This strategy may appear to add a premium, but this premium is explained by the increased exposure to stocks with smaller capitalization.  A similar explanation can be applied to many fundamental weight smart beta strategies2, which focus on balance sheet items like sales, cash flow, or dividends.  Excess returns from these strategies tend to be as a result of any tilt they have toward small or value stocks.  Exploiting the size and value premiums can be an important part of an investment strategy, but it might be prudent to invest in these factors directly, as opposed to backing into them as part of a strategy with an unrelated goal.

Another common systematic smart beta strategy is risk-weighting, or the idea that each asset in the fund is given a weight based on its relative riskiness.  The most popular risk-weighted strategy is volatility weighting, where assets are weighted based on realized volatility, generally measured by standard deviation of returns.  So called “minimum volatility” strategies3 have become extremely popular in the past several years, but have not exhibited excess risk-adjusted return over any sustained period of time.  A newer risk-based strategy focuses on intra-fund diversification, weighting stocks on their relative correlations with each other.  This method tends to result in a higher allocation to smaller stocks (as they tend to be less correlated than larger stocks), and have not been shown to consistently add value above any factor tilts to this point.

The idea of a “smart” index product that achieves risk-adjusted returns that are superior to cap weighted indices is certainly appealing, and certain factor tilts (small and value) have been proven to add value over longer periods of time.  However, there is not a lot of evidence that supports the idea that these smart beta strategies add excess value in excess of their exposure to known market factors.  This does not mean that there are no promising strategies besides those in existence that may provide long-term value.  It does behoove investors and fund providers to consider new investing techniques.  However, this consideration and research should be undertaken with caution and diligence.

1. Volz, Beagan Wilcox,“Doubts over value trigger rise in equity index funds.” Financial Times, 6/23/2013
2. For more information on fundamentally weighted strategies, see our blog post:
3. Low volatility strategies have been a subject of this blog as well:

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About Erik Lehr

Erik graduated from the University of Oregon with a Bachelor of Economics and Mathematics degree. His background includes master’s degree in economics and a Master of Science in Computational Finance and Risk Management from the University of Washington. Erik also holds the Chartered Alternative Investment Analyst (CAIA®) designation.

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