In the first half of 2015 we’ve seen many of our smart beta predictions fulfilled. In particular I’m glad to see that there is more consensus around the definition of smart beta, with investors growing more comfortable with the investment strategy that captures aspects of both traditional passive and active investing. However, we are far from the Smart Beta Promised Land. In the meantime, here are a handful of questions I get most often from investors—so I thought I’d share my answers with you.
Why is smart beta the topic du jour?
Given the prolific attention on smart beta (in the United States alone, the term “smart beta” was searched an average of 7,500 times per month in the past year on Google), you’d think that smart beta is the shiny new bike on the block. We’re the first to admit that many of the concepts behind smart beta are not new—the idea of seeking inexpensive companies (Value investing) or high quality balance sheets (Quality investing) have been part of the active management toolkit for ages. What’s getting everyone’s attention is the ability to capture these potential sources of return in a low cost and transparent form—and we all like the potential to get more for less.
How should I choose a smart beta strategy?
There are lots of types of smart beta available these days, so the strategy you choose should be driven by the outcome you are trying to achieve. The best forms of smart beta are deliberate and transparent in the exposures they deliver, making it easy for investors to determine what’s under the hood. However not all smart beta strategies deliver “pure” exposure, so being mindful of any unintended risks lurking in the portfolio is always a good idea.
Skilled implementation is also critically important. Most smart beta strategies have a higher level of turnover than traditional market cap-weighted indexes, and a slightly less advantageous liquidity profile. Without a skilled portfolio management team in place, transaction costs and tracking error may quickly begin to erode the potential benefits of a smart beta strategy.
Smart beta providers talk a lot about transparency. Why is that important?
Transparency is a defining attribute of smart beta strategies. Like traditional index strategies, smart beta strategies follow pre-set rules to determine the process for security selection, portfolio construction and rebalancing. Often those rules are published by a third-party benchmark provider. That means investors should have full knowledge of construction rules and portfolio characteristics, enhancing their ability to make deliberate allocations and build more diversified portfolios. Smart beta ETFs have yet another layer of transparency in that daily holdings are publicly available.
One thing to note: Those pre-set rules stay set. Those rules have no knowledge of and make no adjustments for changing market conditions.
Where would I implement smart beta into my existing portfolio?
Many investors struggle to think about how to add smart beta strategies to their existing portfolios. Conceptually it is really no different than blending traditional passive and active strategies.
Many smart beta strategies are designed to seek incremental returns. Others provide the potential for less risk (some do both, but let’s start with the simple case). A return-seeking strategy like the iShares® FactorSelectTM MSCI USA ETF (LRGF) can complement traditional active and passive investments as a potential source of incremental return. In contrast, a risk-mitigating strategy like the iShares MSCI USA Minimum Volitility ETF (USMV) can complement your traditional investments as a way to seek potential downside risk protection.
Quantifying your desired outcome, such as an after fee incremental return goal, or a certain decrease in max drawdown, can further refine the asset allocation decision.
Is smart beta just equities?
There are many forms of equity smart beta, but we can apply this way of thinking to any asset class. One of the things I’m most excited about is the work we are doing in fixed income smart beta. As I wrote in my previous post discussing the iShares U.S. Fixed Income Balanced Risk ETF (INC), there are many opportunities for smart beta to re-write the rules of fixed income investing.
Have more questions? Ask away in the comments below or look out for my next post!
Sara Shores is Global Head of Smart Beta for BlackRock.