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Smart beta: equities and beyond

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  • Smart beta equities and beyond

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As soon as one starts edging out of traditional asset classes, identifying market beta – let alone the ‘smart’ version – becomes more and more difficult

In equities, the proposal is simple: you start with market capitalisation, and re-weight according to some rules-based system. In bonds, too, a market capitalisation-based universe is easy to identify – the value of each outstanding bond issue. The fact that this leaves you allocating more capital to the issuers carrying the most debt also makes the case for a smart version from the start; it is no surprise that fixed-income smart beta has dedicated itself to mitigating the risks of indebtedness by re-weighting to take account of issuers’ assets or cash flow generation. 

In commodities, things get a bit more complex, but not much more. There are assets to buy (futures contracts) and sensible ways to decide what market weights are. And again, the problems smart beta can solve are clear: the potential for negative yield from rolling the futures; and the disproportionate weight given to energy in the market or production-weighted indices.

Things get genuinely sticky when we move into currency markets. After all, the currency markets are not made up of a collection of assets, but rather a collection of exchange rates – historical trades, essentially. This is why there is no real currency ‘beta’ bubble in the graphic below, which describes the spread of smart beta out of the equity asset class. Arguments are made for the carry trade as a candidate for a genuine risk premium extractable from currency markets, and sometimes for value and momentum, too, but the academic jury is still out on these questions.

Hedge fund strategies are also a collection of trades rather than assets, really, but a market valuation can be defined by hedge fund NAVs. A fund-weighted composite index then becomes the equivalent of a market cap-weighted equity index for hedge funds. 

Smart beta equities and beyond

If there is a smart version of this beta, it is hedge fund replication. The thing being replicated here varies. It can be a fund-weighted index return, or a selection of common-factor risk premia identified with hedge fund strategies, replicated using derivatives – long small-caps, long credit, short volatility, long merger risk, and so on. More often, today, it takes the form of a simplified portfolio of the core trades associated with a particular strategy, executed directly. As our supplement reveals, there are even efforts to extend this ‘smart alpha’ approach into the long-only active management sphere.

These approaches look similar to currency carry, in that their claim to ‘smartness’ is largely restricted to the potential to enhance net returns thanks to cheaper implementation and end-user costs, rather than the enhanced exposure to risk claimed for smart beta products in equities, fixed income and commodities. 

Volatility, our final candidate for the smart beta universe, is an asset class whose market is made up from option trades. This is volatility beta. Volatility arbitrage, like the currency carry trade, is a putative risk premium masquerading as a (smart or alternative) beta. 

Plain beta, smart beta, alternative beta – what do they all have in common? They are all dedicated to extracting return from markets by taking risks in the simplest and most systematic way possible – and the relative simplicity or complexity will vary depending on what type of risk that is. In this supplement we aim to take a tour of all three – as well as looking at how smart equity beta can be made even smarter through portfolio construction.

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