Investors may now choose a number of smart beta ETFs to fill out a diversified investment portfolio, but where exactly do you put it?
“Investors must take a portfolio-level perspective to determine how a given alpha-generating strategy can enhance overall returns,” Deutsche Asset Management strategists, led by Robert Bush, said in a research note. “Essential to this way of thinking, they must determine the optimal percentage of a portfolio that they allocate to an alpha-generating strategy given the level of tracking error that they are willing and able to accept.”
The Deutsche strategists outline a number of steps investors can take before fully incorporating a smart beta ETF in lieu of traditional investments. For starters, investors should determine an investment’s historical net of fee returns and look to an appropriate benchmark. From there, one can estimate the potential alpha or outperformance an alternative index-based investment would provide.
Investors should then determine whether or not this alpha is statistically significant and economically significant. One should consider the costs necessary to achieve this outperformance, such as the amount of tracking error involved during the process. Consequently, investors should stick to those smart beta strategies that have exhibited high alpha with relatively lower tracking errors, or what Deutsche calls information ratios, to determine the attractiveness of the investment.
Deutsche Asset Management believes alpha over tracking error is a critical way to outline whether or not moves away from the benchmark were justified. The alpha and tracking error pairing, or so-called information ratio, provides a probabilistic insight into the likelihood that a strategy outperforms its benchmark over a given timeframe.
“Our view is that investors should prefer higher information ratios over lower ones in general,” according to the Deutsche strategists. “For an investor who is not constrained by a particular tracking error target, higher alpha-generating strategies even with the same information ratio could be preferred.”
For more information on alternative index-based strategies, visit our smart beta category.