The aim of so-called Smart Beta investing is to combine the benefits of passive investing with the perceived advantages of active but mechanical, rule based investing strategies.
Smart Beta funds aim to beat conventional market capitalization weighted stock indices at a cost lower than traditional actively managed funds. By and large stock picking is a waste of time: over the years no fund manager consistently beats the index. Smart Beta aims to outperform by “re-inventing” the traditional stock market index.
Smart Beta attempts to capture investment factors or market inefficiencies in a rule-based and systematic fashion. The belief is that it is possible to enhance risk-adjusted returns above those available from cap-weighted indices.
According to Morningstar, assets under management in the Smart Beta sector amounted to $616 billion in 2015.
Smart Beta funds are not just for stocks. Smart Beta ETFs have also been designed around bonds, commodities and multi asset classes.
A prime example of a Smart Beta fund is AQR’s International Momentum Fund. Momentum is a simple, well researched and apparently durable concept. The theory is that what goes up tends to continue to go up while stocks on a downward spiral tend to carry on down.
As per AQR:
We invest in stocks of large- and mid-cap non-U.S. companies with positive momentum. A stock is considered to have positive momentum if it has performed well in the prior 12 months relative to other stocks in the investment universe of large- and mid-cap non-U.S. companies.
We employ a systematic approach to constructing the portfolio that starts with the investment universe, ranks the stocks in the universe by their total return over the prior 12 months excluding the last month, selects those that rank in the top third, weights them by market capitalization, and rebalances at least quarterly.
Other Smart Beta strategies may involve tracking low volatility stocks, using different weighting strategies to emphasize the advantages of small stocks, or indeed any other strategy which combines open and transparent indexing of investments while aiming to better the returns from traditional stock indices.
One of the major problems of these techniques was traditionally the secrecy and black box nature of the way such funds were run. For decades Commodity Trading Advisers claimed to have invented some “secret sauce” by which they were able to follow trends in the commodity markets and achieve spectacular returns uncorrelated to stock markets.
In reality such techniques were usually very simple trend following methods and the problem was that in times of market collapse it became very difficult for investors to stick with the “secret source”. Investors were also being scandalously overcharged.
Smart Beta funds have greatly improved the situation by being open and honest about what they are doing, so that investors can stick with a fund through good times and bad.
Over the coming months I will be expanding on my views and pointing out some of my preferred Smart Beta Funds.