Reaching for a better solution: smart beta aims to out-perform the index
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If finance is all Greek to you, you are not alone. Financial theory revolves around two Greek letters, alpha and beta and they in turn have given the investment industry its latest big idea: “smart beta”.

The idea is derived as follows. In modern portfolio theory, the return on an investment is broken down to beta plus alpha. Beta is the return you get from the market. Alpha is that extra return you generate from a particular investment. A stock with a high value of beta is particularly sensitive to market moves, while a high alpha suggests that it is particularly idiosyncratic.

In aggregate, by definition, everybody’s alphas add up to zero, or the same as beta, the market return. Generating alpha therefore becomes the central challenge for investment managers, and it is difficult. The more managers who go out there actively managing portfolios of stocks and looking for wrongly priced securities, the harder and more expensive their job will be.

But tracking beta is cheap and easy: you simply buy an index fund that tracks the market. Index managers can use futures to ensure they match the index and do so very cheaply. They have no need to pay for expensive research.

But there are still issues with buying beta. It involves accepting the market’s judgments at face value and the market often gets prices wrong, as the bubbles and busts of the past few decades make clear. For example, buying a US index that is weighted according to companies’ market capitalisations would have meant buying a lot of tech stocks when they were absurdly overvalued ahead of the tech crash in 2000.

Further, there is an issue that not all asset management can be passive — somebody needs to manage money actively, or prices on securities will not make sense and capital will be poorly allocated.

To try to solve all these problems, fund managers have now created “smart beta” — cheap tracker funds that can beat the market.

They do this by departing from “dumb” or traditional beta indices’ system of weighting according to a security’s market value. A first wave of smart beta funds, which tracked a series of “fundamental” indices launched by Research Affiliates in the US, and by others instead weighted companies according to a formula based on various fundamentals, including book value, dividends and sales. This way, large companies that were out of favour with the market still received a strong weighting and, over time, as they came back into favour, they tended to outperform.

A further wave of smart beta funds were driven by specific factors that academics believe will beat the market in the long run. The most important of these are:

• Size: small companies beat large ones in the longer term.

• Value: cheap companies, compared to their earnings, beat expensive ones.

• Momentum: companies that are winning (in that their share prices are rising), tend to keep succeeding, while laggards tend to keep lagging.

The list of factors has grown over time. Low volatility is also now regarded as a successful factor — companies whose share prices are quite stable tend to do well. “Quality” is another term used for weighting indices and is defined in various ways, but generally means that a company has a strong balance sheet.

All of these factors have performed better than the market in the very long term, according to academic research, but they tend to be cyclical, going through periods of underperformance. So to rectify this there are “multi-factor” funds, which combine several elements under one roof. These begin to open smart beta to the complaint that from an initially simple intuition it is becoming unnecessarily complicated and blurring the line with traditional active management.

Typically, for a smart beta fund you would face only slightly higher fees and costs than you need to pay for a index-tracking fund such as an exchange traded fund or ETF. Proponents of smart beta say for this small extra cost you still get to beat the market. And even with the proliferating products, Intech, the smart beta pioneer, points to one clear advantage of the concept — rebalancing. Smart beta only works if it rebalances regularly, catching up with companies that have grown larger or smaller and trimming back holdings in companies that have grown faster than their fundamentals merit.

Any such regular discipline, provided it does not incur too much in transaction costs, involves regularly selling at the top and buying at the bottom and that can be expected to lead to a reliable market-beating performance. The precise strategy or factor they follow is less important than the fact of rebalancing discipline.

Against that, there are problems. Bill Sharpe, the Stanford University Nobel laureate who drew up the concepts of beta and alpha, says that the whole notion makes him “definitionally sick”. By definition, he contends, such strategies must contain the seeds of their own destruction. As more people try to take advantage of outperformance of cheap stocks or momentum stocks, for example, so their weight of money will steadily eliminate those anomalies.

Smart beta is a great idea and investors should certainly consider it as part of their toolkit. But the industry needs to guard against making it too complicated. And it cannot last for ever.

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