In the world of finance we distinguish between alpha and beta when analysing performance. Beta quantifies the sensitivity of a portfolio to the broader market while alpha measures the outperformance versus a benchmark. But for several years now, we witnessed the rise of smart beta strategies, let’s review what they bring to investors.
Not quite alpha, not quite beta
Smart-beta strategies are often called factor-based strategies however they are slightly different. Both approaches use alternative rules to construct their portfolio as opposed to traditional market capitalization based indices. These rules seek to capture some specific rewarded factors as identified by empirical research. The most common factors are Value, Growth, Size, Momentum, Quality, Volatility and High Dividend.
In “classic” factor strategies a specific factor is overweighted versus the others, as such the strategy is “tilted” towards one factor. Smart-beta strategies, on the other hand, go a step further by seeking to have a constant exposure to the targeted factor while neutralizing all the others, as such they provide a “purer” version of factor strategies.
That’s for the theory because in reality the terms are often misused and erroneously interchanged. But a word of caution for investors, not all factor or smart beta strategies are equal, how the targeted factor is defined and how the fund’s portfolio is constructed play important roles in the end results.
What’s in it for investors?
According to the 2020 EDHEC European ETF, Smart Beta and Factor Investing Survey, investors’ two main motivations for using smart beta strategies are to improve performance as well as better managing risk.
Indeed, empirical research has shown over the years that some factors can provide higher risk adjusted performance than traditional market-cap based strategy. However, this is not a free lunch, not all factors perform well at any given time. Portfolio managers have to analyse which factor is more likely to outperform given their view on the markets.
Figure 1 shows the importance of cyclicality and timing, we can see that following the dot.com bubble Value overperformed both Growth and market-cap based benchmarks. However, after the global financial crisis and since then, Growth has been overperforming substantially.
Figure 1: Comparative performance of Value and Growth factor from 2001 to 2010 and from 2011 to September 2021 – Source: FTSE Russell
There are many way investors can implement smart-beta strategies. First they can tweak an existing portfolio to reflect the targeted style. Alternatively asset managers can invest in an smart beta fund to externalize the process. In this case they seem to favour passive funds over active solutions as reported by EDHEC in the same survey. Such products can be viewed as accessible versions of investing strategies which were traditionally executed via discretionary decisions.
Investors’ appetite for smart beta strategies
Data from the ETF universe provide an relevant snapshot of investors’ appetite for smart beta strategies. According to ETFGI, in June 2021, there were more than 1300 smart beta equity ETF available to investors worldwide totalling $1.22 trillions of assets. In the first 6 months of 2021, inflows into these funds are at a record $93.28 billion in contrast with the $12.99 billion gathered during the same period last year. More importantly assets in smart beta strategies are growing faster than traditional market-cap strategy with a 5-year CAGR reaching 23% versus 20% for vanilla solutions.
Figure 2: Worldwide assets under management in Smart Beta ETF – Source: ETFGI
And there is still room for growth. Indeed, 29% of the respondent to the 2020 EDHEC survey would like to see more development in the Smart beta ETF space. In particular, almost half of the investors surveyed plan to increase by more than 10% their assets into smart beta products. Despite this strong eagerness, current allocation into smart beta remains low with 70% of respondents investing less than 20% of their total assets in these strategies.
Smart beta strategies seek to exploit factors empirically proven to have the potential for enhanced performance and better allocation to risk. Although investors can adjust their portfolio to reflect smart beta strategies, surveys show they tend to favour passive funds, such as ETF, as a transparent and cheap alternative. The growth in these funds has been quite remarkable, as for the last 5 years they have outpaced the growth in traditional market-cap based funds. And with new strategies in the fixed income universe or with embedded ESG features, the smart beta space is not done innovating yet.
1 2020 EDHEC European ETF, Smart Beta and Factor Investing Survey, page 10
2 2020 EDHEC European ETF, Smart Beta and Factor Investing Survey, page 69
4 2020 EDHEC European ETF, Smart Beta and Factor Investing Survey, page 18, 3 and 67