Not All Smart Beta Is Created Equal

With $1 trillion going into Smart Beta at the end of 2017, it’s important for allocators to look under the hood to avoid being disappointed.

Smart Beta has emerged as one of the most popular strategies for allocators in recent years and it’s no secret why—the low-cost products promise the kind of consistent returns that many CIOs expected from active management, but have had a hard time finding. With some $1 trillion in assets flowing into the strategy, according to Bloomberg data, smart beta looks to be here to stay. However, not all factor strategies are created equal. Some of Wall Street’s biggest firms are pointing out that investors could be adding unintended risk to portfolios and trading away performance in an effort to cut costs through the use of off-the-shelf products.

Northern Trust Asset Management’s head of global equity investing, Matt Peron, argues that the problem with many smart beta strategies today is that they can result in a concentrated portfolio that fails to provide clean factor exposure or diversification. “Investors need to understand that there is a clear distinction between smart beta and factor investing,” Peron tells CIO. “Many current smart beta strategies are a roundabout way to get into factor investing and the exposure in those strategies isn’t always clear.” 

Active, Passive, or Actively Passive?

NTAM started to develop its approach to factor investing more than 20 years ago with the goal of achieving higher individual factor returns and a consistent risk-adjusted return. According to Peron, the cyclicality of factors can lead to prolonged periods of underperformance and unintended portfolio risks if factor strategies are constructed poorly. “It is difficult to achieve pure factor exposure, especially if you aren’t actively creating the index for each factor,” Peron says. “Within a multi-factor portfolio, if the underlying indexes for each factor are similar, you can end up with factors offsetting each other or working against each other, which dilutes overall performance.”

NTAM’s approach to factor investing skews more toward active than passive. Peron and his team create and actively manage the exposure for each factor in order to avoid unintended risk and position concentrations across factors. “A combination of clean factor betas allows us to capture excess return,” Peron contends.

NTAM isn’t the only institutional firm taking an active approach to what many investors view as a passive strategy. Vanguard Group recently announced it would bring its smart beta ETFs to US investors, and regulatory filings show that the seven funds Vanguard plans to launch will be actively managed. The firm is offering a mix of individual factor funds as well as multi-factor exposures. Vanguard’s decision is significant, as they are the first concentrated factor exposures offered in the US by the firm. By opting to actively manage them, Vanguard is also signaling that they see rules-based factor investing as an inherently active strategy—a key distinction for a firm known for its passive approach.

 Education is key

As more factor strategies come to market, it will be key for investors to understand what they are actually getting—and it seems few do. A recent investor survey from Brown Brothers Harriman & Co. and shows that 65% of investors view smart beta as a versatile, hybrid strategy, but one-third (34%) of respondents are still unfamiliar with what smart beta actually means in practice.

While smart beta has been billed as a “set it and forget it,” low-cost way to capture equities return, investors will still need to investigate smart beta funds as they would any other strategy to avoid being disappointed. “It’s important for investors to understand the exposure they have in each factor and how that complements their core equity portfolio,” Peron said.

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