The basic zero-sum math of capital markets still holds true: For every winner there must be a loser. What’s differentiated about smart beta is the recognition that there are certain risks (or risk premia, in the language of investment managers) that have been categorically rewarded, like taking on economic or inflation risk. At the same time, there have been forces – often powerful ones – that have driven market prices away from the pack in a predictable way, such as the way so-called value stocks or low volatility stocks tended to outperform over the long term. Many of these ideas have been featured in actively managed portfolios for decades. Smart beta allows investors to capture these themes at a fraction of the cost.
Is there a catch? Well, even the most formidable forces are not immune to market cycles. For example, value stocks can lag in rallying markets as they did, for example, during the mid-2000s. But over a sufficiently long period of time, patient investors may be rewarded for bearing the risks and the discomfort of market cycles. That’s actually the catch: You have to be willing to look past the daily market coverage and invest for the long haul. The good news is that smart beta factors have generally not been correlated with each other – that is, each factor tends to be rewarded at different times of the economic cycle. So they can be a powerful way to implement investment views and can also be powerful sources of diversification in a portfolio.
I’ll take a deeper dive into smart beta strategies and potential uses in my next Blog post.
Sara Shores, Global Head of Smart Beta for BlackRock, is the newest contributor to The Blog.