Smart Beta

Blends passive and active investing to enhance returns and manage risk through alternative index construction methodologies

Author: Nicolas Palmer
Nicolas Palmer
Nicolas Palmer

Student at Boston College Studying Finance and Accounting for Finance and Consulting

Reviewed By: Hassan Saab
Hassan Saab
Hassan Saab
Investment Banking | Corporate Finance

Prior to becoming a Founder for Curiocity, Hassan worked for Houlihan Lokey as an Investment Banking Analyst focusing on sellside and buyside M&A, restructurings, financings and strategic advisory engagements across industry groups.

Hassan holds a BS from the University of Pennsylvania in Economics.

Last Updated:March 15, 2024

What Is Smart Beta?

Smart beta investing blends passive and active investing to enhance returns and manage risk through alternative index construction methodologies.

It aims to capture specific factors or market anomalies and lower risk by increasing portfolio diversification. It is also known as Alternative beta. Smart beta is the evolution of the cap weighting model. There has been a sudden rise in the popularity of smart beta strategies.

We need to understand the origin of basic concepts such as beta, alpha, etc. Beta is used in a popular theory called CAPM (Capital Asset Pricing Model). 

Beta measures a stock's volatility relative to the movement of the overall market. Based on the relative volatility, i.e., the stock's volatility divided by the market's volatility, a beta value is allotted to the stock, with 1 being the benchmark value. 

While traditional beta calculates the weighted average index, smart beta addresses issues of bias by using alternative weighting schemes.

While beta is a valuable measure, its value can be positive, negative, or zero, indicating the direction and magnitude of a stock's movement relative to the market.

Alpha, like beta, is a measure used in investment analysis. It represents the excess return of an investment relative to its benchmark, accounting for the risk taken. Using beta values, it calculates the difference between the stock's actual performance and the estimated value. 

The benchmark value for alpha is 0. If the value is higher than 0, then the strategy performed better than expectations, and if it is lower than 0, it performed worse.

Key Takeaways

  • Smart beta blends passive and active investing to enhance returns and manage risk through alternative index construction methodologies, aiming to capture specific factors or market anomalies.
  • They weight portfolio components based on factors like volatility, value, momentum, or quality, aiming to capture specific risk premiums or exploit market inefficiencies.
  • Smart beta extends traditional beta by incorporating exposure to specific factors or risk premia beyond market risk, enhancing diversification and potentially providing better risk-adjusted returns.
  • Smart beta strategies include alternatively weighted indices (non-market cap-weighted) and factor indices (explicit factor targeting), each with distinct methodologies and objectives.
  • Drawbacks of smart beta strategies include higher costs compared to passive investing, periods of underperformance, higher portfolio turnover, shorter track records, and complexity.

How Smart Beta Works

Smart beta strategies aim to improve upon traditional passive investing by weighting portfolio components based on factors other than market capitalization. These factors might include volatility, value, momentum, quality, or other metrics influencing returns.

Smart beta seeks to capture specific risk premiums or exploit market inefficiencies by deviating from standard market-cap weighting.

Smart beta strategies can be rules-based and transparent, offering investors a clear understanding of how the portfolio is constructed and managed. This transparency contrasts with the often opaque nature of actively managed funds.

The appeal of smart beta lies in its potential to provide better risk-adjusted returns than traditional market-cap-weighted indices, albeit without the higher fees associated with active management.

However, investors must understand the underlying factors and methodologies driving a particular smart beta strategy to assess its suitability for their investment goals and risk tolerance.

How is the smart beta extended version of beta?

Smart beta extends traditional beta by incorporating exposure to specific factors or risk premia beyond market risk, enhancing portfolio diversification.

While beta is a key component of the CAPM model, smart beta strategies are utilized within the framework of various asset pricing theories, including the Arbitrage Pricing Theory.

Firms employ multi-factor models or multivariate linear regression to account for alpha, thereby reducing residual noise in the traditional model.

Traditional market funds may exhibit lower returns than total stock market funds due to their broader market exposure. Total stock market fund returns can be very high as they invest in all the companies on the stock market. 

So what is the issue? Tech companies' valuation is very high compared to other sectors, so they make up a very high proportion of the fund value. 

During market corrections, tech stocks may experience significant declines due to their higher volatility, potentially leading to substantial drawdowns in funds heavily invested in this sector. This issue arises because the fund is capitalization-based.

Note

One important thing to understand is all smart beta strategies are different. It varies from firm to firm. Investors need to look at the various biases and do factor exposure analysis. 

Alternatively Weighted Indices Vs. Factor Indices

We know various strategies use the concept of alternative beta for portfolio optimization; there are two classes of alternative betas:

  1. Alternatively weighted indices:  This strategy is non-market cap-weighted, with an incidental factor exposure.
  2. Factor indices: This strategy uses various risk premia or factors for modeling following iron-clad rules.

Differences between alternatively weighted and factor indices are:

Alternatively Weighted Indices Vs. Factor Indices
Alternatively Weighted Indices Factor Indices
Non-market cap-weighted Market cap or other
Index level objectives Explicit factor targeting
Incidental factor exposure Direct factor exposure
Various methodologies Precision Tools

Disadvantages of Smart Beta

Let's understand some of the drawbacks of smart beta:

  1. These strategies cost more than traditional funds (passive investing)
  2. Since they seek lower volatility, they show periods of underperformance
  3. Alternative beta has a high portfolio turnover compared to passive portfolio investing, along with high expense ratios
  4. Many smart beta strategies have shorter track records compared to traditional passive strategies, making it challenging to assess their long-term performance and stability across various market conditions
  5. These strategies can be complex and challenging for investors to understand fully. This complexity may lead to difficulty in assessing their performance and suitability for investment objectives

Smart beta ETFs

Smart beta ETFs are investment tools that either passively track smart beta indices or actively implement smart beta strategies. These strategies aim to outperform traditional market-capitalization-weighted indices by targeting factors like value, momentum, quality, or low volatility.

Smart beta ETFs offer investors the potential for enhanced returns and reduced risk compared to purely passive investing without the higher fees associated with active management.

However, smart beta ETFs may involve greater complexity than traditional index ETFs, necessitating investors' understanding of underlying performance-driving factors.

Smart beta ETFs offer investors a transparent and convenient means to access these strategies, leveraging the liquidity and diversification inherent in ETFs.

Smart Beta Popularity

Let us understand the outlook on the popularity and future of alternative beta. It is estimated that its usage will increase exponentially.

The number of alternative beta schemes has reportedly increased, mirroring growing investor interest. 

Filtering companies for the fund requires Data Science. Either the Data Scientist or the fund management team handles it. While alternative beta strategies often utilize algorithms for feature selection, fund managers may still play a role in refining or adjusting factors.

Limited historical data on returns may hinder comprehensive future predictions, warranting cautious speculation on the outlook for alternative beta.

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