Traditional market benchmarks, such as the S&P 500 Index, are market cap-weighted, which means that the largest stocks account proportionally for the S&P 500 as a whole. This not only overemphasizes “mega cap” names like Apple and Exxon, but it also ensures that overvalued stocks make up a greater percentage of the index than undervalued stocks, all other things being equal. For these reasons, the “smart beta” approach – which weights proportional allocations by a measure other than market cap – has gained increasing popularity, and it is being implemented within a variety of mutual funds and ETFs.
The Dreyfus Company and Mellon Capital Management recently launched three smart-beta mutual funds and published a white paper by global investment strategist William Cazalet titled Beyond Active and Passive: Using Smart Beta Strategies to Build More Efficient Portfolios. In the paper, Mr. Cazalet makes the case for Mellon’s proprietary multi-factor smart-beta methodology, but not before giving a thorough review of what smart beta is, how it differs from traditional strategies, and the potential drawbacks to some styles of smart-beta investing.
What is Smart Beta?
The term “beta” generally refers to volatility, so that a stock with a beta of 1.0 would have equal volatility to the S&P 500. Stocks with betas greater than 1.0 would therefore have greater volatility than the broad market, while stocks with betas less than 1.0, but greater than 0, would have less volatility than the broad market. Any stock with a negative beta would have a historical pattern of producing losses when the broad market posted gains, and producing gains when the broad market posted losses – this would be a negatively correlated stock.
When investors seek “beta exposure,” it means they want to participate in the return of the market. Of course, beta works both ways, so that a stock with a 1.1 beta would be expected to lose 11% for every 10% lost by the broad market. Smart beta strategies aim to escape the constraints of traditional market cap-weighted portfolio construction by ignoring market capitalization altogether, and using other methodology to determine portfolio weightings.
Active or Passive?
In this way, smart beta funds act a lot like actively managed portfolios, even though they invest under a rules-based approach more akin to passive management. Like passively managed funds, smart beta funds are transparent and low-cost, but they aren’t tied to a capitalization weighted index like most traditional index funds, and thus they don’t behave like them.
By seeking to minimize volatility, many smart beta strategies adopt so-called “risk-based strategies,” according to Cazalet. He cautions that these strategies ignore fundamentals and therefore are exposed to unseen risks. For example, by allocating on the basis of minimum volatility, a portfolio runs the risk of “large and consistent sector bias,” since some sectors are generally less volatile, and this can lead to undiversified, unbalanced holdings. What’s more, there are market conditions under which low-volatility stocks may be overvalued, which would lead to risk-based smart beta strategies overemphasizing these overvalued stocks – just like market cap-weighted indexing.
Instead, Cazalet favors the more “active-like” approach pioneered by Mellon Capital Management, which allocates on the proprietary basis of earnings quality and growth. This leads to a focus on companies with more attractive valuations, as opposed to the emphasis on overvalued stocks that results from market cap-weighting.
There are other fundamentals-based smart beta strategies than the multi-factor approach favored by Mellon, but Cazalet warns that strategies that focus on just one (or one type) of fundamental factors are inferior to those that incorporate a variety of return premiums. “The multi-factor approach enables us to retain a focus on the value-driven components of a stock’s price while taking into account improving company fundamentals to avoid the ‘value trap,’” he says. “The inclusion of quality in our process also provides some measure of downside protection for the strategy since periods of higher risk and risk aversion tend to encourage a flight to more defensive stocks that have quality earnings.”
For these reasons, well-designed smart beta strategies combine the best of both worlds from active and passive investing: The flexibility of the former, with the low fees of the latter, along with enhanced diversification and the potential for superior risk-adjusted returns.