(October 2, 2013) – Smart beta strategies should only be used across a broad selection of assets, according to consultancy Towers Watson.
In a white paper on the adoption and implementation of smart beta strategies—which have become increasingly popular over the past year as investors seek out tax and cost-efficient returns—Towers Watson concluded that smart beta works best when implemented across a broad investment universe.
“Breadth and depth are instrumental to the successful application of approaches that are systematic in nature, such as smart beta. We do not think a narrow or too concentrated opportunity set is suitable for the use of some smart betas,” the report said.
“This might lead to unintended risks, such as over-concentration in certain industries/sectors/countries and/or for stock-specific risk becoming too dominant in the portfolio.”
Towers Watson believes that broad approach should apply to geographical regions too, recommending a universe which features both developed and emerging markets.
While picking developed-only or emerging market-only universes may also work, drilling down to country-specific strategies was not ideal, the paper said.
Investors should be aware of the more aggressive smart beta strategies that may underperform significantly in bear markets or sharp drawdowns.
Perhaps the biggest issue for newcomers to smart beta strategies is how to benchmark results.
It is also important to realise that smart beta strategies are generally not constructed as relative return products, and typically have high tracking error relative to a market capitalisation portfolio, the paper continued.
This means that the strategies will perform very differently to market capitalisation weighted portfolios and can underperform market capitalisation substantially, potentially over a long period of time—typically during strong market rallies and bubbles.
Towers Watson suggests you throw the idea of benchmarks out of the window, and focus on aligning the strategies with the investment objectives, and then monitor them regularly to ensure they are still aligned.
However for some strategies, taking traditional benchmarks and applying them in a different way may be a useful tool.
The paper noted: “For some smart beta approaches, the strategic rationale may be to reduce the overall equity beta exposure of the portfolio (that is, de-risking). In this case, we are supportive of the strategy being measured against a market capitalisation index over the long term on an absolute risk-adjusted basis.
“We would also support benchmarking against a suitable combination of a market capitalisation index and cash (which would be another way of lowering the beta of the equity portfolio or benchmark). In cases where a manager is managing their approach against a specific index (for example, an MSCI minimum volatility index) comparing to said index is also appropriate.”
The full paper can be read here.
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