A New Look at Old Beta

The term has no precise definition, according to Adrian Banner, CEO and chief investment officer of INTECH Investment Management LLC. Smart beta generally describes rules-based investment strategies that do not rely on market-capitalization weighting to set asset allocations within an index-tracking portfolio. 

Historically, smart beta strategies weighted allocation by revenue, earnings and gross domestic product, among other rules. The most popular strategies today, Banner said, include equal weighting, fundamental weighting and minimum variance.

“It wasn’t always called smart beta, but the reweighting element has always been central to these types of strategies,” Banner said.

Put simply, smart beta assumes that better diversification and rebalancing rules can generate returns that exceed the capitalization-weighted index without expanded risk or excessive oversight.

Like indexed investments, smart beta’s most attractive features typically include low management fees, high transparency and low asset turnover.  

“What is new is how these strategies are being positioned for investors,” Banner said. “A lot are being positioned as passive alternatives. Smart beta, it’s said, is a smarter way of passive investing.”

One risk is that investment managers will restrain clients from judging smart beta performance against the more traditional cap-weighted indexes.

“Some smart beta providers are saying that there isn’t just one true benchmark for these products, and they’re calling the strategies themselves a new benchmark,” Banner said. “I’ve found there is extreme variation in perception about the validity of that claim. Some have embraced smart beta as the ultimate benchmark, and others look at it as another form of active investing.”

Hundreds of smart beta offerings are available from many different providers. Some are inexpensive and approach the fees for cap-weighted index portfolios. Others are priced similarly to actively managed products, yet are being positioned as passive investment solutions, Banner said.

When it comes to adding smart beta options to a defined contribution (DC) retirement plan, key factors to consider include cost, transparency, optimization, risk and turnover.

“When you just hear it’s a smart beta strategy, that doesn’t mean that in all those dimensions you’re going to get something similar to a traditional cap-weighted index,” Banner said. “Normally, in at least one of the dimensions there is something that is significantly different from the cap-weighted index.”

Also worth considering: smart beta strategies are not guaranteed to outperform the passive indexes they track. In fact, sometimes smart beta purposefully sacrifices outsized returns for bettter downside protection.

“If you get a 15% return with smart beta, but the cap-weighted index is up 25%, is that good or bad?” Banner said. “It seems awful. You’re 10% behind what was possible. But, on the other hand, you’re up 15%, which will certainly exceed your actuarial assumptions by a long margin. We tell clients that these types of strategies should be considered as part of a well-rounded portfolio.”

To classify that type of outcome, Banner said, it is necessary to look at what was traded for the missed 10%.

“If you got some downside protection, so that if the markets would have dropped 40% as they did in 2008, but your portfolio would have only dropped 20%, then maybe the product is better understood in terms of managing volatility,” Banner said. “After all, if you invest in fixed income, you get less risk but sacrifice returns. For some of this smart beta, it’s the same premise.”