Smart beta presents a beguiling prospect to investors: a set-and-forget investment approach that can regularly outperform market capitalization-based indices. Appearances, however, can be deceiving. Our analysis suggests there’s nothing special about smart beta – certainly nothing that can’t be replicated by using an investment process based on nothing more than the length of a company’s name.
 
The concept of smart beta is far from revolutionary. At its core, the approach repackages style investing as a strategy with the superficial characteristics of an index. With this type of indexing, stock weights deviate from traditional capitalization weights in a way that attempts to beat the market.
 
The recent popularity of the smart beta approach probably has more to do with a growing awareness of the shortcomings of traditional benchmarks than with a resurgence of interest in style based investing. Benchmark shortcomings include an anti-value bias, since market capitalization weighting has a tendency to favor expensive stocks over cheap stocks, as well as a risk of excessive concentration, caused by a momentum bias that pushes investors into themes that have outperformed in the recent past. The result is that larger stocks are favored over smaller ones, leading to an inefficient use of the investment universe.
 
Smart beta strategies do tend to reduce the anti-value bias by breaking the link between market capitalization and weight. But other weighting schemes that don’t rely on market capitalization are likely to work just as well. The weighting mechanism can be anything quantifiable that helps to remove the anti-value bias and return drag from mega stocks. The key is that it should involve some degree of rebalancing back to a value not determined by price movements. In our opinion, it is the act of rebalancing itself, rather than the choice of weighting schemes, that is important – rebalancing helps investors avoid chasing the most overvalued companies.
 
To illustrate the point, we took the MSCI World Index over the last 25 years and reweighted its constituents using two schemes. For the first, we used an equal weighted version and for the second, we used the length of each company’s name, so that the stocks with the longest names were allocated the largest weight in the index. Although this completely arbitrary scheme was divorced from any investment fundamentals, it didn’t suffer from performance bias (e.g. by leaning towards cheaper or lower volatility stocks).
 
It turned out that the length of a company’s name led to higher performance than the MSCI World Index over our 25-year time period and had similar performance to an equal weighted index. The only moment when our non-capitalization ‘index’ lagged behind the MSCI World Index was during the technology bubble of the late 1990s, but it quickly pulled ahead again in the early 2000s. It would seem that investors may materially improve their long-run performance by regularly reweighting the stocks in a standard index back to a non-price sensitive starting point.
 
The Art Of Portfolio Management Is Lost In Smart Beta
Any rules-based strategy that automates the investment process also overlooks the need for skillful portfolio construction, efficient implementation, and good risk management. Smart beta investment products are generally based on automated market responses, with minimal human oversight, and this can result in undesirable concentrations. Since smart beta is marketed as an index-like product, investors may also think that they don’t need to apply the same due diligence that they would when selecting an active manager. Yet the approach’s automated rules may lead to a buildup of unexpected risks and unexpected outcomes.
 
One of the potential issues with market capitalization weighted indices is that they can lead to stock, sector, country or investment theme concentration issues. This can occur when investors buy into themes that are entering a sustained growth period. A self-perpetuating spiral then results, with stock prices pushed higher and valuations becoming more expensive, as happened with Japanese stocks in the late 1980’s or technology and telecoms in the 1990’s. Smart beta strategies may alleviate these problems, but they can lead to other concentration issues.
 
For example, minimum volatility strategies have a tendency to converge on low volatility countries or sectors such as consumer staples, healthcare and utilities. However, low volatility in a company, sector or country may turn out to be a transitory attribute and/or a poor reflection of underlying strength. For example, many financial stocks exhibited low volatility prior to the global financial crisis, but careful analysis of their fundamentals would have highlighted real underlying risks in the form of excessive leverage and elevated funding pressures. Risk on a fundamental basis was highest just when share price volatility was lowest.
 
An additional concern with automated processes is that there is no human being navigating the portfolio through the investment cycle. This may mean sudden and dramatic changes in portfolio characteristics at the rebalancing dates, radically altering the portfolio’s investment themes – a phenomenon that would be considered unacceptable in an actively managed strategy.
 
Such large changes in allocation fail to take into account the changing nature of risk through the investment cycle. Investors might therefore be well advised to closely monitor smart beta products to ensure the risks they are taking are appropriate, and that they maintain positions that match their expectations.
 
Stephen Kwa isSenior Client Portfolio Manager, QEP at Schroder Investment Management NorthAmerica.