AQR co-founder Cliff Asness has a history of speaking out against the concept of “smart beta.” In 2010, Mr. Asness compared smart beta to gambling, saying “if you own something very different from the market, you’re making a bet and someone else is making the opposite bet,” and “I think people should call a bet a bet.”
But now Asness’s perspective has changed – sort of. He still objects to the name “smart beta” and says it’s really a repackaging of quantitative management, a style upon which Asness has built his career. Smart beta isn’t new, but it is worth having in your portfolio, according to Asness and his partner John Liew, the authors of AQR’s whitepaper Smart Beta Not New, Not Beta, Still Awesome.
What is Smart Beta?
Just because Asness and Liew say smart beta is “mostly repackaged, rebranded quantitative management” doesn’t mean they think the rebranding is necessarily a bad thing. In their view, smart beta improves upon quantitative management styles by implementing them in a simple, transparent manner that typically results in lower fees. “That certainly sounds like a worthwhile repackaging,” Asness and Liew write.
But despite smart beta’s dual aim of simplicity and transparency, there’s still a lot of confusion as to exactly what “smart beta” means. Asness and Liew say this likely stems from there being so many related concepts and so much overlapping terminology. They go on to give examples of how fundamental-indexing, systemic value, and momentum investing strategies can all be implemented within various products and all be considered “smart beta” – despite being vastly different from one another. For this reason, Asness and Liew break down their analysis of smart beta strategies into three categories:
- Single factor within a single asset class, and long only
- Multiple factor within a single asset class, and long only
- Multiple factors within multiple asset classes
Basic Smart Beta
The majority of smart-beta funds are single-factor, long-only equity funds, which Asness and Liew refer to as “basic smart beta.” Obviously, the key to single-factor smart beta is selection of the right factor, and Asness and Liew caution investors to avoid “data-mined strategies” designed to “fit history.” Factors that are appropriate for smart beta include value, momentum, and profitability.
A single factor can be implemented one of two ways: (1) By direct portfolio “tilting” or restricting investments; or (2) by using non-price measures in portfolio allocation weightings. A key principle of smart beta is to always offer performance characteristics that are distinct from market cap-weighted benchmarks, and that’s why smart beta portfolios must be constructed by alternate means.
Multi-factor strategies can increase risk-adjusted performance by offering exposure to several uncorrelated smart beta factors under a single strategy. Whereas selecting the single “right” factor is of paramount importance in a “basic smart beta” strategy, multi-factor strategies combine factors that have a low correlation with one another, thereby offering the prospect of more balanced returns. AQR provides the following chart to demonstrate how different factors are in and out of favor at different times:
What’s more, by implementing multi-factor smart beta within a single strategy, stocks that may fail to meet the threshold of any single-factor strategy may be among the most attractive when viewed across multiple styles – in other words, single-factor analysis can let some of the best investments slip through the cracks.
The Next Step
Finally, Asness and Liew consider smart beta implemented in a long/short fashion across multiple asset classes using multiple factors, which they call a “bigger jump” in terms of both “efficacy and risk/unconventionality.” Using simulations from 1999 through 2013, Asness and Liew find a “significant benefit” from combining multiple factors across multiple asset classes in what they call “the next step” of smart beta. This type of advanced smart beta investing also features the flexibility to sell short, which they say “may offer a more diversifying, truly alternative return source.”
Smart beta investing shouldn’t be compared to passive, indexed-strategies, according to Asness and Liew, for which investors typically select managers based on fees alone. Smart beta is an active strategy, according to the paper’s authors, in the sense that smart beta attempts to outperform the broad market. Asness and Liew say they “don’t eschew analysis based on fees,” but instead simply ask investors to keep in mind what they’re purchasing, and not just how much they’re spending.