Smart beta may be the latest trend in the investment community but the concept is far from revolutionary. It essentially takes the core idea of style investing and packages it into a strategy that superficially resembles the characteristics of an index. However, its recent popularity has probably more to do with the growing awareness of the shortcomings of traditional benchmarks than a resurgence of interest in style based investing. These shortcomings include: an anti-value bias due to a tendency to favour expensive stocks over cheap stocks; excessive concentration caused by momentum bias pushing investors into themes that have outperformed the market in the recent past; and they can result in a narrow or inefficient use of the universe which arbitrarily restricts investment to larger market capitalization stocks, crowding out the ability of smaller cap stocks to contribute meaningfully to performance.
In our opinion, smart beta strategies only really address the first of these issues, tending to reduce the anti-value bias whilst doing little to address the issue of concentration and narrow breadth. Indeed, the automated nature of smart beta investment strategies means that they can actually lead to portfolios more highly concentrated on a single theme. As a ‘set and forget’ rules based strategy they can increase investment risk by ignoring the changing nature of risk through the investment cycle. Further, many smart beta offerings limit investment opportunities to those companies in the main market capitalization index, thus maintaining a bias to larger capitalization stocks whilst ignoring more investment opportunities outside of the index. Essentially, smart beta investing is rather simple: we see no hidden alpha that has not been available to active managers for decades.
We believe that a rules-based strategy like smart beta that automates the investment process ignores the fact that portfolio management is also about skilful portfolio construction, efficient implementation and good risk management. Our research suggests it is possible to construct an investment portfolio that meets these requirements while addressing the problems with smart beta. This article will outline what smart beta investing is and how it attempts to deal with some of the issues that have been uncovered with market capitalization benchmark investing. We then explore in more detail the benefits of a non-market capitalization approach. Finally we highlight how smart beta strategies only partially address the market capitalization issues and discuss why we think constructing an investment portfolio addressing all three issues will lead to better outcomes for investors.
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