Picking the Right Smart Beta: The Speed Dating Approach

Choices. They can be wonderful. But all too often, the availability of too many choices leaves us paralyzed and, ultimately, unable to make any choice at all. I’m no wine connoisseur, so when I open a 5-page wine list, I’m instantly overwhelmed. My default: I ask the waiter for a recommendation. The problem with that approach is twofold. First, it’s very possible the waiter knows even less about the wine list than I do. Second, even if the waiter does know each of the wines well, he or she is missing a critical piece of information: my preferences.

In the investment world, advisors face this product proliferation challenge every day as the already vast menu of available “smart beta” or “strategic beta” products continues to grow at lightning speed. After emerging in response to the financial crisis, by December 2010, there were 125 strategic beta products on the market, with $175B in assets under management (AUM)*. According to a recent Morningstar report, those numbers shot to 560 products and $452B AUM by December 31, 2015. And while having choices is great in theory, with 560+ strategic beta products to choose from—and more being added every day—where do you even begin?

Related: Revenge of the Nerds (all Thanks to the DOL)

Of course, taking my wine list approach puts you at much more risk than simply being served a less-than-stellar bottle of Syrah. Unlike choosing a wine for your meal, selecting an asset manager is more like choosing a spouse: you end up marrying the whole family, so you better be darned sure you share their outlook on life! The choice is highly personal, and depends on your own approach and the preferences and needs of your clients. And because choosing the right funds from this set of diverse and highly nuanced products is one of your most important investment decisions, it’s time for some serious speed dating.

Speed Dating 101

The point of speed dating is to cut to the chase. Be honest about what you want, honest about who you are and, ultimately, stop wasting time with anyone who’s not a potential match. While I have no idea how effective it is in the dating world, when it comes to culling down the menu of strategic beta products, speed dating can help eliminate product paralysis by eliminating the wrong choices, identifying potential winners, and helping you make the choice that’s right for you—in a timely manner.

Step 1: Clarify your own philosophy

Before you step out to find the right match, it’s important to be as clear as possible about your own philosophy. While strategic beta products are, at their core, alternatives to passive index investing, how active do you want to go? Is your focus on reduced risk or enhanced returns? Most importantly, what client outcome are you seeking? Every firm has a specialty, and your goal is to identify the one that delivers the best possible match.

Step 2: Create a short list

With your written philosophy as the driver, start eliminating the firms that clearly don’t fit. If you don’t prefer white wines, that 5-page wine list just got cut in half. If you’re more conservative, knock out those asset managers that lean toward a more active approach and focus on those who take a more passive approach. Next, look at the characteristics of their funds. Are the focused on value? Growth? Dividends? What is the expense ratio? Again, cross off the “no-match” options and cull your list down to those with real potential.

Step 3: Perform due diligence

Steps 1 and 2 qualify as speed dating. Step 3 is the real deal. You’ve already made the decision that the firm as a whole is a strong match for you, but a single firm may offer multiple products to choose from. This is the long dinner date (but with a much shorter wine list!), and it’s time to ask some serious questions—and get some serious answers. Remember, your goal is to build on the strategic core or your portfolio, and you’re considering a long-term marriage here, so be careful, be honest, and be choosy. Here are 7 key questions to kick off the conversation:

  1. How was the product created? Is it based on proven fundamentals, or is it designed with new bells and whistles to attract investors?
  2. What are the risk constraints around those ideas? How do you manage success?
  3. Has the product delivered stable, consistent outcomes? How long is the track record?
  4. How does the risk exposure affect the client experience when the product achieves its objectives? What about when it doesn’t?
  5. When has the product over- or under-performed? What were the factors that drove each outcome?
  6. What are the tradeoffs for performance versus risk?
  7. How does the strategy affect the composition of my overall portfolio model?

By now you should have a pretty strong understanding of the product and how it fits with your philosophy, your portfolio, and your clients’ desired outcomes. And just like dating, it’s time to let your intuition kick in. If the product sounds like a good fit, ask yourself: Does it fit my specific needs? Does the asset manager think like I do? Does it feel like they’re in the business of marketing or delivering a solid investment tool? Be honest with yourself and trust your instincts. In the end, you should be able to narrow the menu down to a fund with the right balance of risk exposure, potential for growth, and even personality. Not bad for your first foray into the world of the strategic beta speed date.