Traditionally, investors have had two options when investing in stocks and bonds - buy a passive index or choose an active manager. These limited options require investors to make bold assumptions about the markets. Passive indexing infers that the markets are efficient and thus automatically price-in all available information. On the other hand, active management assumes the markets are inefficient and suggests that skilled stock/bond pickers have an edge. What if there was a way to combine the benefits of each into a single strategy? Within this piece, we discuss Smart Beta investing and how it attempts to do just that.
The Usual Suspects: Passive vs. Active
Passive investing or indexing has been around for decades and is a time-tested way to gain market exposure. Index investments attempt to replicate the returns of a specific index minus fees. Because the investment provider (think Vanguard) does not need a team of research analysts, costs remain low. This allows for returns close to its benchmark index. These strategies fit well for investors who believe market is efficient.
“Most global indexes have one major flaw - they provide more exposure to the largest companies (stock indexes) or those with the most debt (bond indexes).”
Unfortunately, most global indexes have one major flaw - they provide more exposure to the largest companies (stock indexes) or those with the most debt (bond indexes). Within the equity markets, most indexes are cap-weighted. They give companies with the largest market capitalization (market cap = # shares outstanding x stock price) the biggest weighting. The bond market is similar as companies/countries with the most debt are given the largest weighting. On the surface this may sound like a good idea - especially within the stock markets. However, this approach distorts the index, reducing diversification and increasing risk.
Conversely, actively managed strategies (think Fidelity) choose investments from within the index in attempt to outperform it. Their goal is to choose the “winners” and avoid the “losers”. Active strategies come in many forms and tend to be more expensive than indexing. This is due to the extra cost of paying teams of professionals to seek out market inefficiencies. Unfortunately, this additional cost has tended to erode returns and led to underperformance over time. Lastly, choosing a “good” manager is difficult and time consuming.
The Best of Both Worlds
Smart Beta strategies attempt to outperform a reference index by combining positive attributes from passive and active management. They tend to maintain a similar structure to that of a traditional index but with an active approach. For example, a Smart Beta strategy might own most of the stocks within the S&P 500 but put more weighting on companies that are deemed higher quality. Another example may include a larger exposure to securities with lower historical volatility. The aim of these strategies is to actively exploit factors that may lead to outperformance while maintaining a low cost structure.
These types of strategies can be used in a variety of ways within a portfolio. Some investors pair or even replace traditional investment strategies with Smart Beta investments. Depending on the strategy chosen, the investor might be attempting to achieve long-term outperformance or just reduce volatility. Either way, it’s critical to recognize how a specific Smart Beta strategy is constructed before choosing it.
“Even Smart Beta investments have a few drawbacks.“
As with many new products, even Smart Beta investments have a few drawbacks. One example is the potential for high internal expenses. Unfortunately, many investors overlook expenses in the Smart Beta space due to the misconception that all indexes are low cost. It’s important to review the total cost of owning an investment when conducting due diligence. Data mining bias is another potential drawback. Many Smart Beta providers handpick strategies that have performed well in the past or during specific periods of time. These strategies may lead to future underperformance and investor dissatisfaction.
Smart Beta strategies provide a 3rd choice to investors deciding between active and passive options. The goal of Smart Beta investing is to combine the positive characteristics of both options into a single investment. Many Smart Beta strategies offer a lower cost than active management while avoiding the pitfalls of owning a cap-weighted index. Even so, they come with their own set of shortcomings. It’s import to review the total cost of ownership before making a selection. Also, avoid chasing returns by choosing an investment simply because it has done well in the recent past. Finally, investors should recognize that Smart Beta investments come with risks and can underperform. With that being said, more choices are a good thing and a positive for the investment industry as a whole.
As always, please feel free to contact us with any questions you may have.
William Kring, CFP®, AIF®
Chief Investment Officer
Matt B. Bailey, CFA®, CMT®
Source: Research Affiliates