Smart Beta Evolution Targets the DC Space

The potential for enhanced returns with reduced risks and costs would seem appealing to any plan sponsor, but what is really behind the label “smart beta,” and can it work in DC plans? 

In a world of low yields and heightened volatility, investors are exploring different ways to navigate the market and reduce uncompensated risk; some are turning to “smart beta” strategies with a degree of success, and the corporate defined contribution (DC) space is taking notice.

Generally speaking, smart beta refers to investment strategies that are based on an index but use alternative weighting or other modifications to the index allocations to achieve some end—typically reducing risk or increasing potential returns compared with the original index.

The broad label includes index-based portfolios reweighted based on factors such as dividends, correlations, volatility, value, etc. And while it sounds a bit like active management, smart beta is theoretically meant to live somewhere in between passive and active strategies. Naturally, the costs of smart beta strategies come down somewhere in between active and passive management, as well, making plan sponsors curious but cautious about smart beta.

Global financial research firm Cerulli Associates puts smart beta fund costs at an average of 25 to 50 basis points, depending on the complexity of the strategy and how it is actually delivered.

Today, investment managers like BlackRock are applying smart beta to target-date funds (TDFs). Last November, the firm rolled out its LifePath Smart Beta series. Like a typical lifecycle fund, its asset allocation focuses on higher returns for a younger investor and de-risking as he nears retirement. The “smart” approach comes with the automated adjustments of the relative exposures to stocks that may be of higher quality or of lower volatility than others in the benchmark index, given an individual investor’s long-term needs.

“For younger investors, we set the exposure based on a basket of factors: momentum, value, size and quality,” explains Nick Nefouse, head of BlackRock’s U.S. and Canada DC investment and product strategy team. “Those are factors we think will help us outperform the cap-weighted index. But by the time you retire, you’ll predominantly be sitting on low volatility factors.”

BlackRock ran a series of analyses comparing the performance of multiple market-cap indexes for a hypothetically constructed working lifetime to that of its smart beta portfolios. These smart beta funds used the same underlying investments but weighted them by factors other than market cap. In all cases, the smart beta portfolios outperformed their traditional indexes, according to BlackRock.

NEXT: Challenges for smart beta portfolios 

Of course, while factor-based investing seeks to outperform a given cap-weighted index, there is no guarantee it will, and any investor moving into smart beta must carefully study the specific products they are presented with.

A report on the concept by Cammack Retirement Group cites the performance of the PowerShares S&P 500 High Beta ETF, which outweighs securities that are supposed to have higher sensitivity to broad changes in the equity market. Thus, they are expected to generate higher-than-average returns in up-markets—but they may very well drive extra loss in negative markets. There is obviously also the risk that a portfolio that focuses too much on a specific factor could suffer accordingly when that factor underperforms or fails to be the most relevant over a given time period. To counter these risks, many investment managers take on a “multi-factor” and “multi-strategy” approach.

“The inherent problem with these products is they tend to provide exposure to one factor at a time,” explains Jay Jacobs, research director at Global X. “Just as we look toward diversifying stocks and stock-specific risk, multi-factor strategies look to diversify factor-specific risk. Over the long run, you can hopefully capture those historical premiums that have been associated with these factors, but at the same time diversify the risk of any one factor underperforming and being a drag on the performance of the strategy.”

Global X applies smart beta to exchange-traded funds (ETF), where much of smart beta is being deployed. However, Jacobs notes that investors’ long time horizons could be a catalyst for smart beta in DC plans. 

“This is a great advantage for factor investing in general,” he says. “Factors can fall in and out of favor. They can be a little volatile among each other. But what we’ve seen over long periods is that they tend to support outperformance. You can ride through some of those factor-specific risks and hopefully reap some of those rewards in the long term.”

NEXT:  Analyzing Smart Beta 

Experts stress that it is important to remember smart beta is a “catch-all” term that each provider will have its own definition for. That’s why it’s extremely important for plan sponsors and advisers to evaluate these products closely. And as noted, smart beta strategies can build around several “factors” that managers believe will support outperformance, and definitions of these factors will also vary among providers.

“It takes a good amount of homework,” explains Jacobs. “You have to dig into the methodology. How are they defining these factors? How are they approaching risk in that portfolio?”

Nefouse agrees that one of the biggest challenges with moving smart beta further into the DC market will be around education, but he believes it could ultimately “deliver an A+ strategy for DC.”

“We think that these strategies can add incremental returns adjusted for risks,” he suggests. “But we have to spend some time educating people. We see this a two-to-three year opportunity, not a 2017 opportunity.”

Nefouse further observes that even the concept of a target-date fund, now so ubiquitous, took years to gain traction. This is likely the path forward for smart beta as well: According to a 2016 survey by Cerulli Associates, asset managers report that only about 11% of smart beta products are available to corporate DC plans.

“More education needs to be promoted to bring investors up to speed with some of these new strategies,” Nefouse concludes. “We think it’s worth it because the returns can be very robust.”

The “Cammack Retirement Investment Research: Is Smart Beta Right for You?” report can be found at More information about Cerulli Associates research be found here