Refuting the myths around smart beta

ETF and fund flows confirm that smart beta investment strategies are popular. But there remains some confusion about the construction and application of smart beta strategies within the ETF space. Smart beta (also referred to as strategic beta, alternative beta or factor-based indexing) is far from a homogenous group of investment strategies.

The term applies across a variety of investment approaches that share two common elements: they’re passive and rules-based. Smart beta strategies employ different weighting methodologies beyond the capitalization-weighted approach used in most traditional indices. Capitalization-weighting represents the total invested capital in a market, or beta, and single- factor-based (e.g., low volatility, dividends) or multi-factor-based weighting (e.g., fundamentals) represent smart beta.

Here are three common misconceptions.

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1. Smart beta is just active management under a different name.

If this were true, smart beta ETFs would be the cheapest active management available.

Smart beta indices are passive, but go beyond the traditional capitalization-weighted index. Traditional indices tend to overweight overvalued companies and underweight undervalued securities, which often leads to a return drag (or negative alpha) as mispriced securities correct over time. Smart beta does share one attribute with active management: it offers the potential to outperform, or reduce the risk associated with, the cap-weighted index. Both cap-weighted and smart beta indices apply predetermined rules to the selection and weighting of securities. Most strategies in either category take a systematic approach to adding or deleting securities and rebalancing. The main difference is that smart beta strategies use alternative screening and weighting methodologies to market cap. Low volatility index strategies seek to reduce the risk of equity investing by owning the least volatile stocks in a benchmark. Fundamental index strategies seek to improve the returns of an equity portfolio by breaking the link between stock price and weight in an index, thus reducing the negative alpha inherent in the cap-weighted index. Similarly, smart beta bond indices may weight securities based on the ability of issuers to service their debt, or ladder a bond portfolio to minimize interest-rate risk while managing cash flow for the investor.

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2. Smart beta second-guesses the wisdom of the market.

A cap-weighted index reflects the aggregated information, beliefs and expectations of all market participants regarding the value of constituent securities in that index. Advocates of this approach claim that financial markets are efficient, investors are rational and that securities prices always fairly and accurately reflect all available relevant information.

Reality tells us that markets are not always efficient, because investors are not always objective and rational. To claim that the market is perfectly efficient at pricing assets ignores the common occurrence of both bubbles and panics, and the correction of mispricing over time.

Smart beta strategies provide investors different ways to outperform, often by reducing the inefficiency of traditional passive strategies. For example, over the last market cycle from January 2, 2007 to December 31, 2014, the S&P/TSX Composite Low Volatility Index significantly outperformed the overall S&P/TSX Composite Index, while maintaining a lower volatility profile. And, the low volatility strategy faced less than 50% of all downside movements and only 71% of the volatility (as measured by monthly standard deviation).

3. Smart beta doesn’t give you the market portfolio.

Based on the various methodologies available, this is a given. But what defines the market portfolio? If cap-weighting is the only true way to access the market portfolio, shouldn’t there be agreement as to which cap-weighted index represents the market? One firm alone offers four different Canadian cap-weighted equity ETFs. Surely, they cannot all represent the market portfolio. While these ETFs aren’t necessarily bad investments, even a critic of smart beta would have to admit there are different rules across these products.

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Some critics have written that “active managers and rules-based passive managers both believe they possess information not represented in the market cap of the stock.” This suggests that cap-weighted indices apply no rules to select constituent securities and their weight in the index. But, as with any other passive strategy, cap-weighted indices are rules-based, and weight securities by their market cap.

Judging by the assets gathered in some of the largest traditional cap-weighted ETFs, there is an appetite for this approach to passive investment. But, cap-weighted indices are not always the best choice for investors seeking a passive approach to investment. By focusing on factors beyond the simple size of a stock or bond, smart beta strategies can help reduce volatility, improve returns and lower the overall risk of a portfolio.

Annualized Performance January 2007-December 2014 (not annualized if less than 1 year)
	1 year	2 years	3 years	4 years	5 years	Analysis Period
S&P/TSX Composite Low Volatility Index	16.56 %	14.42%	14.24%	13.99%	15.09%	7.25%
S&P/TSX Composite (Blended)	10.55%	11.77%	10.22%	5.15%	7.53%	4.56%
Source: StyleADVISOR

Risk/Return Table Annualized Summary Statistics: January 2007-December 2014
	Standard Deviation (%)
S&P/TSX Composite Low Volatility Index	10.23
S&P/TSX Composite (Blended)	14.47
Source: StyleADVISOR

by Michael Cooke, head of distribution, PowerShares Canada.