By Mike LaBella, Portfolio Manager at QS Investors
1. Names Do Not Matter
Smart beta means many things to many people. Defining characteristics typically include investment strategies that are simple, transparent and rules-based. Many names are used: factor investing, anti-benchmark, strategic beta, advanced beta, scientific beta, alternative beta, enhanced indexes, quantamental indexes, quasi-active, alternative-weighted, anti-beta … Yet few of these names are actually descriptive of the resulting investment outcome, which vary widely due to the starkly different approaches employed by these strategies.
2. Outcomes Do Matter
The best way to show how smart beta works is to start at the end. Generally smart beta ETFs are intended to achieve two investment outcomes: core exposure (style neutral and broadly diversified), and style investing (value, momentum or defensive). They can reduce exposure to volatility, reap unrecognized potential that investors tend to ignore, take advantage of market trends by riding waves of positive sentiment, or offer efficient ways to capture upside potential. All can be designed to work in specific market environments, which may underweight a short-term opportunity for the benefit of the long-term strategy. Buying smart beta means investing in outcomes.
3. Human Behavior Impacts
The return premiums expected from smart beta are grounded in investor biases which are systematic in nature, as opposed to unsystematic misjudgments of a stock’s fair value. Understanding why illuminates when smart beta can perform best. Over the long term, value stocks have outperformed growth stocks. Some explain this as the result of overly-confident investors too-optimistically extrapolating companies’ growth prospects. Defensive stocks have historically outperformed the market on a risk-adjusted basis, which may result from investors being drawn to stocks with lottery-like pay-offs. This would cause growth and risky stocks to be over-represented in capitalization-weighted indices, which are usually – predictably – on the “wrong side” of behavioral biases.
4. Diversification Requires Effort