What does smart beta really mean?

Smart

• • Intelligent, keen, bright.
  • Clever, witty; impudent (don’t be smart).
  • keen in bargaining; quick to take advantage; shrewd.

Beta

• Second letter of the Greek alphabet.
• In finance, a measure of a stock’s sensitivity to market risk. A security with a beta of 1 has the same volatility as the market; less than 1 has less; greater than 1 has more. If a stock’s beta is 0.75, it is 25% less volatile than the market; a stock with 1.25 beta is 25% more volatile than the market.

Smart beta (n.)

• Describes passive investment strategies that weight an index, using factors such as volatility and dividends, to try to deliver better risk-adjusted returns than conventional capitalization-weighted indexes.

Sources: The Canadian Oxford Paperback Dictionary; Dictionary of Finance and Investment Terms, (Seventh Edition); “Smart Beta versus Smart Alpha” by Bruce I. Jacobs and Kenneth N. Levy, The Journal of Portfolio Management, Summer 2014; corporatefinanceinstitute.com; “Better Days for Active Management?” by Lori M. Heinel, State Street Global Advisors

The term “beta” evolved from Harry Markowitz’s modern portfolio theory (MPT), out of which the capital asset pricing model (CAPM) and terms such as beta and alpha were later developed.

Beta refers to the fact that a security’s “risk and return is related to its relationship to a market index,” says Eric Kirzner, a professor of finance at the Rotman School of Management in Toronto. “If you want a portfolio that pretty well matches the index, and you’re not looking to outperform, then you’d have a portfolio with a beta of close to one,” he says.

Alpha is the excess return over the index. In between is smart beta, which involves constructing indexes based on non-traditional factors such as earnings, book values, sales, dividends and cash flow. Factor-based indexes are deemed smart “because someone has thought about them and hasn’t simply accepted cap- or price-weighting,” Kirzner says.

Still, smart beta is often tagged as passive. According to a 2014 paper out of Jacobs Levy Equity Management in New Jersey, “Smart beta strategies are neither forward-looking nor dynamic,” since weightings are chosen at the outset and the indexes use “rules-based selection and weighting, with rebalancing at predetermined intervals.” In contrast, more active approaches—such as smart alpha—involve researching stock prices, making forecasts and responding to market trends, the paper says.

Though smart beta strategies have been used by passive managers—namely institutional investors—since the 1970s, the term was coined by risk and insurance firm Willis Towers Watson in the early 2000s.

In a 2013 paper, the firm sought to refine the term. It contrasted smart beta with basic “bulk beta” and more active, tactical alpha, saying smart beta should offer efficient market exposure but in a “simple, low-cost, transparent and systematic manner.”

Evolution of smart beta

Beginning of the smart beta boom. The term was first adopted in the early 2000s to describe the concept of taking “what had been wrapped up in an active mutual fund structure and making [that] rules-based, indexed and within an ETF structure. The industry needed a term that would resonate with clients,” says Jeff Weniger, asset allocation strategist at WisdomTree Asset Management in Chicago, who saw the term becoming popular about 10 years ago.

Marketing mania. “It’s a good marketing term [because] it’s captivating and engaging, but I’m not sure investors truly understand it,” says Christopher Doll, vice-president of ETF sales and strategy at Invesco Canada in Toronto. Why? “Smart beta gets lumped in with a number of different terms” such as intelligent indexing and factor-based investing, he says. While these terms can be used interchangeably—they’re “all different terms used to describe an index that selects and weights its securities differently than traditional market cap-weighted indexes”—sticking to one is less confusing for investors.

Product evolution. The distinction between beta and alpha is strong within the industry, but the smart beta market is increasingly “being sliced and diced,” says Doll. A growing number of products are using investment factors such as low volatility, dividends, value and momentum, and “providers are offering strategies that blend two or more factors to help investors achieve their investment objectives,” he adds. As well, different weighting mechanisms are being used (e.g., equal- or yield-weighted), which is further fragmenting the space.

How to explain it

Provide context along with the definition. Canada’s tech bubble is one example of how smart beta indexes and products can be useful. In 2000, Nortel had a market cap of more than $250 billion, says Doll, and “it ran up to 35% of the index.” Yet the company’s contribution to the Canadian economy didn’t warrant that domination, he says. A factor-based, as opposed to a cap-weighted, index would have weighted Nortel differently and could have fallen less when Nortel collapsed.

Consider the tracking error. “Any index with a tracking error of within 2% is more of a beta index,” says Weniger. The further you get away from that, “you become less and less able to use the term ‘beta’ in your definition.” WisdomTree prefers the term “modern alpha” to show it’s using in-house methodologies aimed at outperformance, versus more closely tracking a known index, he adds.