The term “Smart Beta” has been around for years, but does a rose by any other name provoke as much controversy? People generally don’t like the “smart beta” name, but it has slowly ingrained itself in the investment world to the extent that it’s now unlikely that alternatives such as “strategic beta” or even “alternative beta” are likely to take hold. And yet, despite the recognition that smart beta is likely here to stay, there still isn’t a great, single, agreed-upon definition for the term. With its new research report titled Smart Beta: An introduction to its uses, Russell Investments hopes to add clarity to the discussion.
Defining Smart Beta
Russell defines smart beta strategies as “transparent and rules-based,” and designed to “provide specific exposure to risk factors, market segments or alternatively-weighted indices.” Smart beta strategies may be disparate in practice, but all adhere to the following key attributes:
- They capture specific exposures;
- They’re transparent;
- They’re “mechanistic” or passively managed; and
- They’re low-cost, relative to actively managed strategies.
Strategy and Factor Based Indices
Russell divides the smart-beta world into two hemispheres: Strategy indices and factor indices. The former include fundamental and equal-weighted indices designed to alternatively weight the total market. The latter are means of stock selection and are based on factors that include value, growth, size, illiquidity, momentum, quality, and income that have been shown by academic research to be sources of excess returns.
Of the two, Russell shows a firm preference for factor indices, citing advantages including “they allow investors to isolate investment decisions and gain the exposures they require” and that they’re “based on persistent characteristics and behaviors,” which makes Russell “reasonably confident that they will continue to behave” in the way they’ve behaved in the past. By contrast, strategy indices are derided for illiquidity issues and “challenges of persistency.”
Using Smart Beta
Russell declares the benefits of smart beta to include the potential of increasing the certainty of investors’ desired outcomes. This is achieved through factor indices “more precisely and more efficiently” capturing the exposures desired by the investor, rather than letting their investment outcomes be influenced by incidental factor exposures.
Russell says smart beta can be used throughout the investment process. This includes strategic design, portfolio construction, and ongoing management, as outlined below:
- Strategic design: Smart beta can be used to better align a portfolio to an investor’s needs.
- Portfolio construction: Smart beta within an existing portfolio can offset aggregate manager biases to improve the efficiency of active management within a portfolio.
- Ongoing management: Smart beta can be used to keep the portfolio on course through market cycles by shifting exposures in a low-cost tactical manner.
Selecting a Smart Beta Strategy
Smart beta can be used to fulfill one or more of the following investment objectives:
- Enhanced returns;
- Better portfolio risk management;
- Increased diversification; and
- Cost reduction.
Of course, not all smart beta indexes or strategies are created equally. While smart beta itself may be passively managed, selecting a smart beta index is an active decision. Investors should be sure to devote due diligence to understanding the objective of individual smart beta strategies selecting them for their portfolios, as they must align with their views and overall investment goals in order to make sense. Ongoing monitoring is also required to ensure the strategy remains consistent with the investor’s requirements.
There is no “silver bullet” in investing, and no sure things. No beta could ever be “smart” enough to guarantee outperformance, but with its myriad advantages, smart beta may be a good place for many investors to start.
For more information, download a pdf copy of the white paper.