Here today, here tomorrow – why smart beta is not a fad

Are you happy to leave your portfolio in the tender hands of whatever the markets do, regardless of your convictions? Of course not.

The traditional investment approach of high-conviction, long-only strategies is facing challenges on performance and cost.

The terms may change, but market exposure in a cost-efficient way is putting pricing pressure on traditional strategies

Schemes simply will not pay active prices to mimic the market when they can do that through truly passive, and cheap, vehicles.

And for active returns they are turning to a new generation of long-only vehicles, less constrained by benchmarks, or to pure absolute return strategies using long-short skills.

Today, investors want transparent strategies from both ends of the active to passive spectrum, with cost-efficient smart beta strategies offering a diversified alternative to traditional passive, market cap-based investing.

That means smart beta, systematic alpha or whatever its next iteration is labelled, is far from a fad because the past 15 years have shown the limitations of exposing portfolios to market-cap indices.

Constructing a portfolio

In fixed income markets, a market-cap approach lends money to the most indebted firms. But that is like giving a man in a hole another shovel hoping it will help him climb out. Better by far is to spot and lend to those companies best able to repay.

And in equities, betting one company will outperform another just because the first is bigger is not only illogical, over time it simply does not generate the best returns for your risk.

The next smart beta evolution in equities is factor-based investing. This can build portfolios that screen investments on the basis of five factors: value, size, volatility, quality and momentum, and then combine them in different ways.

Two years ago, the market was still grappling with the simplest forms of smart beta, taking a first step beyond the market-cap big-is-beautiful tradition. Now the most sophisticated pension funds in the Netherlands, Scandinavia, the UK and some sovereign wealth funds are already applying these five filters to construct portfolios and implement their investment views.

They are using factor-based smart beta as a way to access market returns in a way that actively implements their investment views.

So which five factors work? Not all are created equally.

Value, for example, wins over a very long period, say two decades. But investors need the skills, or to access the skills, to combine factors in a way that is most robust for their investment horizon, and then to make sure they are not just reintroducing some of the old market-cap biases and equalise the risk across that selection. 

There may be wrinkles in the construction of smart beta portfolios, there are certainly debates about which factors to combine to deliver the best Sharpe ratios, depending on your time horizon, and how to time exposure.

But one thing is clear, systematically constructed smart beta, rigorously applied and then actively managed to adapt as the economic environment changes, is delivering more robust returns than traditional market-cap approaches at considerably less cost for the risks run.

Smart beta is not a short-lived fad. It is not even new. The literature on the subject goes back more than a decade and some strategies, especially in fixed income, already have a five-year track record.

The technology, and need, for more robust alternatives to the boom-bust battering on offer from market-cap investing has caught up with the theory.

The terms may change, but market exposure in a cost-efficient way is putting pricing pressure on traditional strategies. Now why would that go out of fashion? 

Carolina Minio-Paluello is deputy chief investment officer at Lombard Odier Investment Managers