Smart Beta 

Following the substantial loss incurred via large cap and growth stocks during the 2000-2002 bear market, investors have sought to diminish portfolio volatility and protect their principle from loss. Again, in 2008, the desire to integrate an exit strategy into investor portfolios became more pronounced. Hence, came the smart-beta strategy.

Smart-beta strategies are best thought of as an active investment strategy. This is because they reflect the specific views of their managers who proactively design their funds to acquire alpha-the excess return above their benchmark. Like traditional active managers, these managers choose a set of securities based on their belief in the securities potential to outperform. 

Although an actively managed strategy, they contain components of a passively managed strategy. By adhering to a strict factor methodology, or algorithm based investing protocol, they shift through securities based on performance and alternative factors. The fees associated with this strategy are much cheaper than other active management strategies, while the returns can be much greater.

A Side by Side Comparison

Let’s ponder these scenarios.

[A] Should investors focus only on some factors?

  • Dividends
  • Assets
  • Cash Flow
  • Book Value
  • Sales
  • Volatility

[B] Or, do other factors matter, too?

  • Profits
  • Competitive landscape
  • Management effectiveness
  • Corporate governance controls
  • Expected Growth
  • New products/lines/business
  • Regulatory environment
  • Accounting irregularities
  • Off balance-sheet items
  • Share repurchases
  • International Operations
  • Expectations
  • Leverage
  • Liquidity
  • Counterparty exposure
  • Supply chains
  • Industry outlook
  • Business model
  • Hedging activity
  • Input prices
  • Natural disasters
  • Market share

Scenario A investing is an example of an investment style where stocks are attributed a market capitalization weighting, then integrated into an investment portfolio based on this weighting. Typically, higher weighted companies have a high market capitalization. These stocks are titled “large-cap stocks”. Small capitalization stocks are titled “small-cap.”

This investment methodology inherently overweights (buy signal) equities that are overvalued (expensive) and underweights (sell signal) equities that are undervalued (cheap), exposing investors to potentially lower returns with increased risk. We want to do the opposite. Because historically, traditional market-cap index strategies have underperformed strategies that focus on metrics. 

Scenario B investing focuses on alternative index construction rules. Managers adhere to metrics such as the ones listed above and consider weightings such as volatility, liquidity, quality, value, size and momentum.

The Smart-Beta Strategy

The term “beta” is simply a measure of a stock’s sensitivity to the movement of the overall stock market. For example, a company with a Beta greater than 1 is more volatile than the market (likely to deviate from the standard return). If less than 1, it is less volatile. If negative, returns can negatively correlate the market. By understanding the stock’s beta, we can build a portfolio that matches our client’s risk tolerance.

Rather than relying on market exposure to determine a stock’s performance relative to its index, smart-beta strategies allocate and rebalance portfolio holdings. When designing a portfolio, we may decide to integrate a smart-beta strategy. They are actively monitored, rebalanced and potentially protect principle from market downturns. We call this an Exit Strategy.


Advanced Smart-Beta

Smart Beta was formerly known as Advanced Indexing. This strategy is designed to increased your expected return by weighting the securities in your portfolio more intelligently. Beta, the measure of volatility, is used in the Capital Asset Pricing Model, which calculates the expect return of an asset based on its beta and expected market returns. What does this all mean? Let’s find out.

Smart Beta and ETFs

In September of 2017, smart beta exchange-traded funds made headlines by hitting record highs. An ETF, or exchange-traded fund, is an investment fund that trades on the stock exchange, much like stocks. Smart Beta ETFs use rule-based systems for selecting investments to be included in a fund portfolio.

Single vs. Multi-Factor Smart Beta

Smart Beta funds come in two flavors-single factor and multi-factor-depending on the factors influencing the funds’ risk return profile. These factors might include volatility, liquidity, carry, momentum, value and quality. Single-factor smart beta leverages one factor when creating an index and multi-factor smart beta leverages multiple factors.

Examples of Smart Beta Strategies

Smart-Beta is a fairly new investment strategy that has recently been implemented throughout the previous 10 years to help counter downward movement in the market. Let’s review our strategies in depth.


The Difference Between Market-Cap Weighting and Fundamental Weighting

Market-Cap Weighting uses a company’s market price and the number of outstanding shares to determine the percentage weighting of the company’s inclusion in the index. The larger the components, the moire that company will allocated to a given portfolio. On the other hand, Equal Weighting distributes the same investment amount into each company stock in the same amount. All companies, regardless of their capital size, will be represented equally.

Performance of Smart Beta Strategies

Strategic implementation of smart beta strategies yield higher returns, on average, in comparison to other benchmark oriented indexing strategies. To deliver sophisticated ways of building index-based portfolios, these solutions apply alternative logic and academic research to weighting methodologies used in index construction, leading to a tailored client experience and higher returns.

    Smart Beta Strategies vs. Factor Investing

    Factor investing looks at characteristics that help investors understand the behavior of an asset. Factor portfolios are generally thought of as a long/short portfolio, where the investor is long equities that have high exposure tot he factor and short equities that have low exposure to the factor. The factor return is the difference between the two. On the other hand, smart beta is typically long only and looks at company fundamentals. 

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