In a world of low yields and heightened volatility, investors are exploring different ways to navigate the market and reduce uncompensated risk; some are turning to “smart beta” strategies with a degree of success, and the corporate defined contribution (DC) space is taking notice.
Generally speaking, smart beta refers to investment strategies that are based on an index but use alternative weighting or other modifications to the index allocations to achieve some end—typically reducing risk or increasing potential returns compared with the original index.
The broad label includes index-based portfolios reweighted based on factors such as dividends, correlations, volatility, value, etc. And while it sounds a bit like active management, smart beta is theoretically meant to live somewhere in between passive and active strategies. Naturally, the costs of smart beta strategies come down somewhere in between active and passive management, as well, making plan sponsors curious but cautious about smart beta.
Global financial research firm Cerulli Associates puts smart beta fund costs at an average of 25 to 50 basis points, depending on the complexity of the strategy and how it is actually delivered.
Today, investment managers like BlackRock are applying smart beta to target-date funds (TDFs). Last November, the firm rolled out its LifePath Smart Beta series. Like a typical lifecycle fund, its asset allocation focuses on higher returns for a younger investor and de-risking as he nears retirement. The “smart” approach comes with the automated adjustments of the relative exposures to stocks that may be of higher quality or of lower volatility than others in the benchmark index, given an individual investor’s long-term needs.
“For younger investors, we set the exposure based on a basket of factors: momentum, value, size and quality,” explains Nick Nefouse, head of BlackRock’s U.S. and Canada DC investment and product strategy team. “Those are factors we think will help us outperform the cap-weighted index. But by the time you retire, you’ll predominantly be sitting on low volatility factors.”
BlackRock ran a series of analyses comparing the performance of multiple market-cap indexes for a hypothetically constructed working lifetime to that of its smart beta portfolios. These smart beta funds used the same underlying investments but weighted them by factors other than market cap. In all cases, the smart beta portfolios outperformed their traditional indexes, according to BlackRock.
NEXT: Challenges for smart beta portfolios