By moving away from the market portfolio smart beta solutions add risk, argues Jeff Molitor. Investors need to be aware of this, and of the fact that taking active risk needs to be well timed

The word ‘smart’ has come to represent a product innovation that takes a tired old design and injects it with new vitality. In mobile telecoms, the smart phone has revolutionised the way we communicate and consume data. In the car industry, the word is associated with a quirky new take on urban driving. Now ‘smart’ has arrived in the fund management industry and investors are being similarly wooed by its positive connotations. But, before we get too carried away, let’s take a step back and assess just what ‘smart beta’ is and where its limitations lie.

The use of the word ‘smart’ is supposed to convey an aura of superiority – that the portfolio has now been optimised in some way.  In reality, though, smart beta portfolios simply focus on a sub-set of the investable universe. In so doing, they cut down the overall opportunity set and reduce portfolio diversification. In some instances this will be desirable and beneficial, but investors who think that a certain sub-section of the market will provide persistent outperformance – however that sub-section is defined – are likely to be disappointed.

Many different types of smart beta products have been launched, but they can be broadly grouped into four approaches:

• Rules-based active strategies. These use pre-determined quant screens to include or exclude certain stocks or sectors, or to re-weight an index – perhaps to give a greater emphasis to smaller companies. A rules-based strategy can appeal to investors with specific beliefs or requirements, such as an SRI mandate that wishes to exclude certain industries.  This approach can also be used to create products that focus on a given group of stocks – so-called positive selection – to allow investors access to a favoured sector or market theme.
• Factor beta. In a specific example of positive selection, the factor beta approach focuses the portfolio on stocks with given characteristics such as value, growth, momentum, size or yield.  Weighting a global portfolio by GDP rather than market capitalisation also falls into this camp.
• Strategy beta. Here, the focus is on portfolio construction rather than stock selection or sector strategy. Often, the whole investment universe will be included but it will be re-weighted in order to reduce volatility, for example. In this case there is no consideration of what kind of investment is likely to be best rewarded in the current environment; merely a view on expected volatility and the wish to mimic the overall market return more smoothly.
• Data miners. This is the strangest approach of all and can result in esoteric products whose rationale is hard to discern to the outsider. We have seen ‘smart bond betas’ that use variables such as land mass as a component of the country weighting calculation, but also allocate a hefty portion of the fund to emerging market currencies. Creating an index on this basis seems odd but, more often than not, the key seems to be a good set of back-test results.

When considering these ‘smart’ approaches it is important to remember that each of them includes an element of risk. Each one results in a portfolio that differs from the overall investment universe; and usually they result in a smaller opportunity set. By deviating from the overall universe the portfolios include an implicit view on the future performance of the included and excluded investments. So, in reality, smart beta investing means taking an active bet on a factor, a style or someone else’s views.  Unfortunately, that bet is all too often based on recent performance trends and, as we have seen many times, betting on recent winners rarely represents a successful strategy. Indeed, it can be a recipe for sharp losses.

Loser’s game
Investing in smart beta products also requires an element of market timing. How do we know whether a factor that has outperformed over the past three years will continue to deliver over the next two? If we are honest, we don’t know.  Very few investors have managed to succeed in timing market rotations over the long term, either within or between asset classes.  In his book Winning the Loser’s Game, Charley Ellis highlights the reality that, like tennis, successful investing for all but the top players is more about not losing than winning. Most investors playing with ‘smart betas’ are playing a game they are more likely to lose than win.

It’s easy to be influenced by product development innovations and marketing pizzazz, but successful investors invariably stay focused on fundamental questions such as: What am I actually investing for? What is my time horizon?  How much risk am I prepared to take? And what am I prepared to pay? Any investment that gives the wrong answers to these questions – or, worse still, doesn’t give any clear answers at all – should set alarm bells ringing. Smart beta may be cheaper than potential alpha, but it might not be as cost-effective as a well-managed index approach and it also involves risks that can be hard to pinpoint.

For the vast majority of investors, it can be more productive to focus on diversification and adopting a long-term asset allocation strategy that is aligned to their goals and to resist the temptation to tinker or invest in the latest ‘smart answer’. Implementing the required asset allocation through conventional beta products may help to reduce the scope for unwanted risks and should also help to minimise costs.

Smarter than the market?

But what about sophisticated investors who have a strong view and wish to implement it?  Perhaps the investment committee has concluded that we are in a structural bull market for high-yielding stocks, or that Europe will be out of favour over the long term. Surely there is a smart beta product that will help these investors to put their high conviction views into action? Well, there probably is, but such investors should be frank with themselves about what they are doing and about their ability to succeed.

Do they really think that they are ‘smarter’ than the rest of the market and that they have identified a theme that will persist over the long term? Some themes do last, but in reality the market has too many clever operators for any advantage to be sustained – in practice it is invariably arbitraged away.  And even if a theme appears to have legs, recent history has shown us that even long-term trends can be upset by violent rotations in the shorter term. Timing these rotations and consistently optimising exposure is a rare skill indeed, even among the investment elite.

If you have the skill to identify persistent themes and have mastered the art of market timing then good luck to you – but be honest and understand the risks you are taking. The ‘smart’ in smart beta is ultimately a marketing confection. It is not a perpetual alpha machine – such a machine has not yet been invented.  Smart beta can be a useful addition to your toolbox, but it has not changed the immutable laws of the market, so use it with caution and don’t be tempted to invest too much faith in it.

Jeff Molitor is chief investment officer, Vanguard Asset Management, Europe