Pitcairn Update, November 2017
By R.J. Smolenski, CIMA®, Director of Research
Click here to download the printable pdf version.

You can’t pick up an investment publication these days without reading about smart beta. It’s not hard to see why. The universe of smart beta options has exploded over the last five years. In that same time, inflows have grown beyond $500 billion, often at the expense of traditional, active equity management. Giant financial conglomerates like J.P. Morgan, Blackrock, and Goldman Sachs now tout their smart beta strategies as leading components of their product pitches. The smart beta buzz is not limited to these banking institutions. More traditional asset management firms such as Legg Mason and distribution companies like Mainstay are heavily promoting their smart beta approaches. Perhaps most notably, index investing behemoth Vanguard is getting into the trend.

Yet despite its growing popularity and influence, coming up with a functioning definition of smart beta is easier said than done. In fact, many of the definitions that have been shared and spread about smart beta are either woefully oversimplified or in some cases, flat out wrong.

While smart beta is the hot trend investors are flocking to, many are doing so without a complete understanding of what they’re getting into. That’s never a good thing. Before we dispel three of the most common myths about smart beta investing, there are some fundamental elements of smart beta that everyone should understand.

Breaking down “beta”

An understanding of the smart beta landscape must begin with a few definitions. Beta is a mathematical calculation that measures the volatility of a single asset, or assets, in comparison to any basket of securities, often referred to as “the market.” A beta of <1 is said to be less volatile than the market, >1 more volatile, and 1 the same volatility. It’s important to reiterate that beta is a measure of volatility, not a performance experience. An asset with a beta of 1 does not necessarily mean it will track the market, it will just have the same volatility. As such, no measure of beta equates to index performance tracking.

When it comes to “smart beta,” there are a few elements common to all the strategies that fall into the smart beta category.

  1. All smart beta strategies involve alternative index construction.
  2. All smart beta strategies are rule-based.
  3. All smart beta strategies utilize investment factors.

A closer look at factors

The focus on investment factors is key. Factors are simply characteristics of individual stocks or markets that are measured financial ratios or are observed by stock trading activity. Types of commonly observed factors include value, growth, size, earnings quality (profitability), yield, momentum, and volatility. Smart beta strategies involve identifying these factors in markets and developing rules-based investment approaches around them.

For example, one smart beta strategy could invest in the top 100 stocks in the S&P 500 from a low price to earnings (value). Another strategy may invest in the 50 highest dividend payers (yield) in the S&P 500. The stocks in these investment strategies are driven by the rules – if a single stock falls out of the top 100 in value or top 50 in yield, it is replaced by the stock that now meets the rule. Note that, in each of these examples, the investment provides a degree of assurance of a beta of 1 to that factor – not the overall market – and even a beta of 1 does not equate to a specific investment experience.

Think of factors like different types of vehicles – a person with a long commute may want a small, fuel efficient car. But when it comes time to drive the kids to sports practice or head out on vacation, that small vehicle with limited space is no longer practical. In that case, a van or SUV may be a better option. In this way, relying on a single vehicle – or factor – can be limiting and may not yield optimal results.

With this foundational understanding established, let’s take a closer look at three common myths surrounding smart beta – and the truth behind them.

Myth #1 – Smart beta is a new approach to investing

The first smart beta ETF (exchange traded fund) was launched about 10 years ago, but investing strategies focused on factors is far from a new concept. The Center for Research in Security Prices (CRSP) at the University of Chicago has been tracking factors since its formation in 1960. Even before that, professional investors pioneered prioritizing many of the most notable factors recognized today. These investors include Ben Graham, whose prioritization of value dates back to the 1930s, and academics Gene Fama and Ken French, who are known for tracking size as a factor. In each of the above cases, these visionaries realized the potential for an above-market return with a focus on factors.

The 1970s saw the rise of multi-factor modeling, beginning with combining value and size-factor investing pioneered by Fama and French. In the car analogy above, multi-factor investing is like having both the fuel-efficient sedan and the SUV in your garage.

Over the years, profitability and momentum were added as common elements in multi-factor approaches. But, as is often the case, the devil is in the details. The way a portfolio is constructed using these factors can present wildly different results not unlike relying too heavily on a single-factor smart beta strategy. There is no one-size-fits-all approach to smart beta portfolio construction.

Myth #2 – Smart beta is just index investing tilted to achieve above-market returns

Many financial publications describe smart beta as passive index investing tweaked to achieve above-market return, but not to the extent that it becomes an “active” strategy. This definition is an oversimplification that ignores the meaningful pockets of risk that exist in many smart beta strategies. Residual risk, in comparison to market risk, is indeed active risk.

Even the most established factors have degrees of cyclicality, which introduces significant risk to smart beta strategies. Factors like growth and momentum, for instance, tend to outperform during periods of economic expansion and in a commensurate rising market. Other factors, such as high dividend yield and value, tend to outperform in down markets, along with declining interest rate and weak macro environments. As with any narrow approach, weighing a single factor too heavily opens portfolios up to risk. Smart beta has many advantages, but consistent above-market returns are far from guaranteed.

Myth #3 – All smart beta strategies work as investment solutions

While the rules-based, factor-driven investing strategies that define smart beta rely on fundamental market drivers, one must be careful to use them appropriately, as few methodologies constitute an entire investment approach or “solution.” Single-factor strategies, with the added risk brought on by cyclicality, are best used as “tools” or building blocks in a portfolio. Certain multi-factor strategies may also be best suited as tools, depending on the concentration of those factors in a portfolio. Others are designed as well balanced, factor-tilted solutions that can better withstand periods of factor cyclicality.

For investors who favor passive investing strategies, smart beta can indeed create opportunities for above-market returns. But as described above, not every approach will generate these returns, and consistency will vary. Smart beta strategies carry risk, and it cannot be overstated that these strategies vary considerably. Understanding the factor or factors being utilized, the concentration of the factor exposure, the number of stocks representing that exposure, and how the overall strategy is built and managed is crucial in defining whether you are considering a tool or a solution.

The Pitcairn approach

Pitcairn puts high value on constructing a balanced portfolio that mitigates risk through a diverse selection of asset classes and a strategic approach to investment selection. We recognize that not all smart beta strategies will be successful, and smart beta is but one technique among many other tools that must be balanced to create a unified investment approach. What’s more, we also utilize, traditional managers who use factors in their screening and evaluation of stocks for their portfolios. As such, it would be safe to say that every Pitcairn client takes advantage of factor-oriented investing, should they maintain a smart beta component or not.

For nearly a century, Pitcairn has capitalized on emerging investment trends such as smart beta without being blinded by the publicity that develops around them as they gain popularity. We have relied on factor-oriented investing since before smart beta made headlines and have closely monitored the research and analysis outlining the advantages and limitations of the smart beta approaches along the way – and will continue to do so.

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