Can Plan Sponsors Be Smarter About Smart Beta?

October 24, 2014 (PLANSPONSOR.com) - Smart beta is fast becoming a popular approach for providing retirement plan investors with a different, yet systematic, equity exposure than that offered by traditional capitalization-weighted indices.
By PS

But is smart beta really a new idea?

The short answer is “no”—systematic alternatives to cap-weighted schemes have, in fact, been around for more than 30 years.

Since that time, cap-weighted portfolios have attracted trillions of dollars from investors around the world, becoming the proxy for the market return, and “beta,” the accepted industry shorthand for exposure to the market. So why are investors now (finally) accepting the notion that alternative weighting schemes should be taken seriously?

Perhaps it’s because many retirement-plan investors find themselves in the unenviable position of wondering how they will meet their retirement goals. After the lost decade (January 1, 2000 through December 31, 2009), which saw the S&P 500 Index down .95%, and the global financial crisis eroded the wealth of so many investors, many pension plan investors are now wisely seeking higher returns with reduced risk, and more controlled costs.

As far back as the early 1980s and long before the term smart beta was coined, systematic weighting schemes, designed to improve upon the inherent flaws of cap-weighted index portfolios, began to emerge. For example, Dr. E. Robert Fernholz, founder of INTECH, published a paper in 1982 in which it was  demonstrated that not only is a cap-weighted index an inefficient portfolio, but that a higher return can be generated with similar risk to the index by simply better diversifying the portfolio holdings—and rebalancing. Other practitioners and academics in the investment management industry have since put their own “tilt” on alternatives to cap-weighted portfolios.

As previously noted, the term “beta” is synonymous with market returns, aka, passive investing. While cap-weighted indexation is inexpensive, it comes with a number of shortcomings, chief among them are overexposure to overvalued and large stocks and the lack of downside protection. Even an index fund has a reasonable chance of losing half its value in a 12-month period. Smart beta approaches purport to offer the same low-cost, passive approach as cap-weighted index portfolios, but are designed to exploit risk factors (i.e., value, volatility, size, etc.) to generate a higher return at the same or less risk. They are sometimes called “alternative” index portfolios, as they employ weighting schemes based on measures other than market capitalization.

But are these strategies truly passive; is smart beta really smart; is it really beta; and what about the risks?

Decades ago, Nobel Prize-winning economist William Sharpe defined “beta” as a measure of a stock or portfolio’s sensitivity relative to the market—a beta of 1 means the stock or portfolio is perfectly correlated to the volatility of the market; a beta greater than 1 means it is more volatile than the market; and a beta less than 1 means the stock or portfolio is less volatile than the market and can be expected to rise or fall less than the market. Than how can beta become “smarter?”

The most often provided answer is that smart beta taps into various risk premia and/or behavioral anomalies that cap-weighting overlooks and which are responsible for improved performance. This explanation, however, neglects to take into account the crucial fact that, unlike cap-weighted indexes, smart beta strategies are not buy-and-hold—they require trading and rebalancing to maintain their respective exposures. This can have a surprisingly positive impact on long-term performance, and may also provide a cause for concern in the shorter term (as a result of practices such as overcrowding and front running).

There is only one true beta. And by labeling it as “smart” doesn’t change the fact that these so-called smart beta portfolios are based on systematic, formulaic weighting schemes used to find the appropriate weight of each stock in the portfolio. Additionally, the only true passive strategy is the cap-weighted (buy and hold) index, which represents the market. Any strategy that identifies and attempts to exploit a targeted fundamental factor can be successful only through active trading. Without any periodic systematic maintenance of the desired factor tilts, the targeted benefit is missed and/or eliminated as the portfolio falls victim to style drift due to market activity.

So how can investors be smarter about smart beta?

The common element of all non-cap weighted smart beta strategies is the need to rebalance. It is this very rebalancing activity that is actually the principal driver of the return enhancement and leads to better risk management. Most smart beta strategies tap into this rebalancing premium accidentally, while pursuing their own particular factor exposure objective.

But if rebalancing is the true underlying alpha source, shouldn’t it follow that the truly “smart” approach would be to pursue this very alpha deliberately and efficiently—in other words, “smart alpha?”

Smart alpha means:

  • reweighting a portfolio from cap-weighting to potentially  more efficient weightings;
  • using portfolio-level risk controls to increase efficiency further;
  • trading effectively, with an eye toward resistance to overcrowding and front-running effects; and
  • the ability to customize portfolio solutions to meet client needs based on risk budgets, return targets or funding status.

 

It is true that smart beta has the potential to generate long-term returns above cap-weighted indexes without picking stocks or forecasting stock returns. And, portfolios comprised of factors are potentially low-cost ways to take or remove explicit factor bets in a portfolio. However, most smart beta portfolios suffer from the dangers of inadequate risk controls relative to the benchmark, overcrowding/capacity issues and sub-optimal implementation. As a result, smart beta portfolios often introduce many unintended sources of risk into a multi-strategy portfolio.

Because better returns may come from better risk management, smart alpha is a means by which investors saving for their retirement can deliberately tap into the common return source of the most popular smart beta strategies, but in a way that is designed to make the best use of this return source in a risk-controlled and targeted framework.  

 

Richard Yasenchak, CFA, Client Portfolio Manager, INTECH  

 

This article is for general informational purposes only and is not intended as investment advice, as an offer or solicitation of an offer to sell or buy, or as an endorsement, recommendation or sponsorship of any company, security, advisory service or product. This information should not be used as the sole basis for an investment decision. Past performance does not guarantee future results. Investing involves risk including the loss of principal and fluctuation of value.  

Any opinions of the author(s) do not necessarily reflect the stance of Asset International or its affiliates.

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