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The Anatomy

April 2016

Smart beta investing tries for an optimal balance between passive cap-weighted strategies and active strategies. But how really smart this strategy is?

Broadly, smart beta can be defined as an umbrella concept for rule-based investment strategy or strategies that don’t use the traditional market capitalization weightings which are often criticized for giving sub-optimal returns by giving greater weight to overvalued stocks and thereby underweighting the undervalued stocks.

The interest in smart beta was triggered after the global financial crisis during 2007-08, prompting investors to focus more on controlling risks than just strive for maximization of return. It also reflects the changing trends in the world of investment. Over the years, investors increasingly opted for index investment owing to its inherent transparency, lower fees, consistency and passive management. But the interest in non-market cap index increased after investors took major setbacks in large caps during dot com crash.

According to Investopedia, smart beta defines a set of investment strategies that emphasize the use of alternative index construction rules to traditional market capitalization based indices. Smart beta emphasizes capturing investment factors or market inefficiencies in a rules-based and transparent way. The increased popularity of smart beta is linked to a desire for portfolio risk management and diversification along factor dimensions as well as seeking to enhance risk-adjusted returns above cap-weighted indices.

Diversification happens to be a key criterion in case of a smart beta portfolio along with other dimensions. In the first place, smart beta approach should help identify factors or themes which are ignored and not well captured in primary asset classes, thereby offering diversification to investors. In the same manner, while seeking smart beta factors we should look for ideas that have not been captured. Further, a smart beta strategy should on its own be sufficiently diversified by not being excessively concentrated in a particular country, sector or security.

A number of smart beta strategies are relatively new and have not undergone a test of efficiency. It is therefore critical that these strategies are put to use by portfolio managers having an understanding of the wider implications. It is the resultant balancing of cost, risk and return that together ensures that an investor’s return matches the intended outcome of the strategy. The manager should stand as an extra line of protection for smart beta investors.

World’s largest asset management firm BlackRock states that smart beta strategies seek to capture broad, persistent drivers of returns. Combining elements of both traditional passive and traditional active investing, smart beta strategies seek to outperform traditional index strategies by targeting intuitive and well understood investment ideas in a rule based manner.

“By combining characteristics of both passive and active investing, smart beta strategies allow investors to retain many benefits of passive strategies while seeking improved returns or reduced risk. Smart beta is not simply a fund or strategy—it’s a different way of thinking about investing beyond traditional active and passive management”, says Sara Shores, global head of smart beta at BlackRock.

There is a proliferation of equity related smart beta strategies and resultant wide options for investors. The role of asset managers and consultants turn critical here and they are being increasingly called upon to sort the meaningful from the meaningless ones. A smart beta investment strategy is developed based on the goals of the investor, which usually is varied.

The application of smart beta beyond equities is in a state of infancy. However, the next category of smart beta could likely find application in fixed income, multi-asset solution as well as in alternatives. Smart beta has a potential to enhance investment results. It can offer incremental returns, reduce risk as well as costs while improving transparency. Investors stand to gain from inclusion of smart beta in the portfolio.

To conclude, higher return is not the motive around which the concept of smart beta revolves. The key driver is the desire to diversify and have a better risk reward ratio. One of the arguments for smart beta strategies such as equal weighted indexing is that they remove the emphasis on the stocks in the index with largest market cap weightings. When these stocks underperform, they will have a sizable impact on the performance of the index relative to the smallest components of the index, says Investopedia.

Did You know??
Smart beta emphasizes capturing market inefficiencies in a rules-based and transparent way
Diversification happens to be a key criterion in case of a smart beta portfolio
A number of smart beta strategies are relatively new
The application of smart beta beyond equities is in a state of infancy

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