There are plenty of interesting questions surrounding smart beta investment in an institutional context. First, does it work? Apparently it does, as academics find more and more evidence that it pays to have passive exposure to factors such as value, low volatility and small-caps.
Second, how transparent should providers of smart beta strategies be about the way they build their indices? Clearly, the more transparency, the better, as it is about investor protection. But can too much of it distort the market, as it gives opportunistic investors a chance to pre-empt smart beta investors that use transparent index-rebalancing rules?
Third, and this is a more philosophical question, can there be too many passive (including smart beta) investors in the market? Clearly the answer is yes, although no one knows what is the tipping point, and most would agree that we are extremely unlikely to reach it any time soon.
But in general for pension funds, smart beta makes a lot of sense. It is a lower-cost, long-term strategy that exposes investors to risk that is systematically rewarded, and isolates them from stock-specific risk.
But does smart beta protect pension funds from the problem of finding successful active managers? Hardly. For many investors, adding a smart beta portfolio simply does not seem to reduce the amount of necessary due diligence, relative to active managers searches.
But one could suggest that smart beta has only a small real advantage over active management, other than its lower cost and potential outperformance. If the strategy underperforms, investors can blame the wrong method of building the benchmark, which is arguably a technological shortcoming, rather than poor human decision-making.
Finally, we have not asked the most important question about smart beta: how is it defined? It appears that it is best defined by what it is not – a market cap-weighted index strategy – rather than what it is. This is all the more relevant in the context of smart beta fixed-income strategies, which are starting to become popular. Quite a few of the ‘smart beta’ fixed-income strategies that are out there are not actually smart beta, in the sense that they do not provide passive exposure to factors – they need active management to work. Investors ought to pay special attention to this, as two products with the same name might not be built in the same way, or produce the same results.