What Is Smart Beta?

A new way of thinking about market efficiency

5/27/15

An old investment idea has been rebranded and is once again capturing the attention of the mainstream investment world. It is called “smart beta.” The basic idea is that investors can improve on traditional market indices by making small adjustments to their composition in order to capture verifiable sources of excess return. These sources of return are referred to as “factor tilts.” The strategy involves increasing the overall exposure to a specific factor, or investment trait, which has been shown to increase returns over time without increasing risk.

The primary factors that have been touted in the academic literature are value, momentum, low volatility, and illiquidity. However, each of these has its own characteristics that must be taken into account.

Value – Researchers have identified a tendency for value stocks (stocks that trade at a low price compared to their sales, cash flow, or book value) to outperform market indices over the long-term. Therefore, there is an argument for favoring value over growth stocks in general.

Momentum – It should come as no secret that stocks that go up tend to continue to go up in the short-term. Stocks that perform well tend to capture the attention of investors, causing new money to flood in. However, this factor can be very difficult to exploit consistently.

Low Volatility – Investors can often be classified as long-term investors or as speculators. Investors seek to increase their wealth over the long-term while speculators are out to get rich quick. Studies have shown that speculators are drawn to high volatility stocks, typically overpaying in the process. Therefore, avoiding these higher risk stocks can actually produce higher returns for investors over time.

Illiquidity – Illiquid investments, those that do not trade very often and therefore can be costly to sell if forced to do so at a bad time, are not the right fit for everyone. Therefore, they have a tendency to sell at lower prices in order to compensate investors for this increased risk. However, investors that can bear this risk have historically achieved higher returns for doing so.

The smart beta resurgence has led to an increased variety of investment options. Investment companies are attempting to capitalize on the smart beta research by offering investment products that seek to exploit the factor-tilts that academic researchers have identified as persistent over time. This has led to a number of enhanced-index options that overweight value stocks, momentum stocks, low-volatility stocks, and illiquid stocks. While many of these investment options are not a big departure from existing investment strategies, they all do not lend themselves to an enhanced-index approach. For example, attempting to invest in momentum stocks through an index is likely to mean that you will be late to the party, missing a large portion of the upside but possibly capturing the downside when prices correct. In addition, investing in illiquid stocks is not for everyone. If investors need access to their money during a period of market turbulence, they may find that illiquid investments have incurred the largest losses, making it a poor time to sell.

On the other hand, the value and low-volatility strategies have shown a large enough statistical persistence that they are a good fit for enhanced-indexing. However, investors should be aware that the expected outperformance from these strategies occurs over the long-term. In the short-and intermediate-term, it is common for these strategies to underperform the market.

It should also be noted that, as with any winning investment strategy, the more people who know about it and attempt to replicate it, the less effective it will be. Therefore, the increase in popularity of smart beta strategies may actually be their undoing if too many investors seek to capitalize on the factor-tilts being touted.