Investment strategy is kind of like Greek alphabet soup. The beta component represents an investor’s return on a passive portfolio that simply earns a risk-adjusted return when compared to the overall market. On the other hand, active portfolios have managers who try to beat beta by earning a higher excess return. The alpha component is the measure of how well the active portfolio manager beats the market at its own game.
Experience, however, shows that it is difficult to achieve alpha consistently year after year. The strategies that worked so well one year might not work well next year. Achieving alpha should be easier because investors have more information available today than at any point in the past. Yet, it almost seems that with more technology and information available, it can be even more difficult to achieve alpha. That’s because we simply can’t process all the information available to us.
How do investors use smart beta?
Smart beta is a way for investors to use information to think differently about forming passive and active portfolios. Rather than forming market portfolios by market capitalization, smart beta portfolios weight assets using a variety of other factors. These factors represent the specific risk tolerance, return goals, and investment objectives of the investor. Smart beta is a way for investors to re-think the creation of their market portfolio.
Rather than relying on market capitalization alone, smart beat portfolios use all of the market information to build a better market index portfolio. The Russell RAFI Index, for example, is a market index constructed using smart beta concepts. Rather than simply looking at measures of a company’s size, the Russell RAFI Index ranks and weights companies using five years of data related to a company’s dividend payouts and share repurchases, cash flow from operations, sales dollars, and leverage.
How is smart beta used to create portfolios?
There are two main strategies for using smart beta to construct a portfolio. The first type is an alternative weighted index portfolio employing index level investment objectives. These can involve strategies such as minimum variance, GDP-weighting, equal weighting, and risk efficiency within the portfolio. Using smart beta in this type of portfolio construction is considered a risk-weighted strategy. In FTSE Russell’s 2016 Smart Beta Survey, 46% of respondents said that they had initiated evaluation of smart beta in their portfolios because they wanted to reduce the volatility associated with their equity investments.
The other type is a factor-based portfolio construction strategy. These target specific factors and utilize a variety of tools to identify and appropriately weight the portfolio according to those factors. These can involve constructing a portfolio based off of objectives regarding size, value, low volatility, quality, yield, or momentum. Researchers have shown that there are many factors that are statistically significant in explaining and forecasting stock performance. Academic and empirical evidence, however, supports these sets of factors as being the most consistently important over time. A factor index embeds a set of these factors in a transparent, replicable, and consistent manner. Rather than simply thinking about a stock having one beta that represents its return profile compared to the market, smart beta considers that stock to have multiple betas related to each individual factor.
What is the future of smart beta?
As investors and advisors seek to achieve alpha, they are paying more attention to smart beta. Using smart beta to create an index or a portfolio has allowed both investors and institutions to create increasingly sophisticated portfolio allocations. The truth is, however, that smart beta is not really that smart anymore. It is a smarter approach when compared to simple buy-and-hold strategies and simplistic portfolio weighting. The general concept of trading on a particular set of value drivers is not new or unique. Similarly, smart beta portfolios currently utilize past data on a set of factors. The future of a truly smart beta, however, should involve complex relationships between factors and predictive data.
Artificial intelligence technologies are able to sift through the enormous amount of data being generated every day on financial instruments to generate predictive data about prices and volatility. The use of predictive data is changing the way investors think about the markets. Rather than relying on past data for portfolio construction, investors are able to create smart beta portfolios using predicted future factors. In addition, AI allows investment strategy to find and capitalize on return drivers before opportunities get traded out of the market. To be really smart in today’s market, investors need to leverage technology in a way that brings to light new data and relationships.