Differentiating Between Factor and Smart Beta Investing

When it comes to factor investing and smart beta investing, it can be easy to simply lump the two together into their own faction of investing strategies. However, Rob Arnott, founder, and chairman at Research Affiliates, otherwise known in the space as “The Godfather of Smart Beta,” debunked the myth of both factor investing and smart beta investing as synonymous subjects.

From the outset, the two seem one and the same, but Arnott begs to differ.

“No—and this is an area of particular sensitivity to me,” Arnott said in a Wealth Management.com article. “The RAFI concept was the inspiration for the term smart beta. We didn’t coin the term. The folks at Towers Watson in London in 2007 coined that expression. They loved the idea of the Fundamental Index. They realized it didn’t win because of the fundamentals, but because of the rebalancing. So they asked the question: What other strategies win by means of rebalancing?”

Both Have Their Own Individualities

While both stray from the tried-and-true passive index investment strategy, both offer their own individualities when it comes to approaching the capital markets.

“The answer to that question is any strategy that doesn’t weight on market cap or on share price is going to have a rebalancing alpha,” said Arnott. “That includes equal weight, it includes minimum variance as long as the strategy doesn’t anchor on cap weighting indirectly by, for example, matching the sector weights of the market. Any strategy that breaks the link with price, that does not weight on price, should earn alpha from rebalancing.”

“Factor investing starts with cap weight and then puts on a tilt,” he added. “Does that meet the original definition of smart beta? No, not at all. A tilt could be smart, it could be stupid, it could be propitiously timed because a factor is trading unusually cheap or is a popular trendy factor that’s trading very rich and is therefore very dangerous. But it’s not smart beta.”

One of the keys in differentiating the two is the manner in which the markets are approached—for smart beta, it’s discipline.

“Smart beta is used to refer to any strategy that is vaguely disciplined, vaguely quantitative, vaguely formulaic, no matter whether it’s smart, stupid, have high turnover or low turnover,” said Arnott. “Smart beta, as we define it, means a strategy not linked to share price, a strategy that does not reward companies with a higher index weight just because their share price has gone up. To label momentum investing, for example, as smart beta is just mistaken.”

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