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Is Smart Beta About to Get Smarter?

Smart beta strategies occupy an intriguing area between active and passive management, often combining the best of both, says Morningstar's Al Kellett

Alastair Kellett 27 March, 2013 | 4:33PM

As the debate rages on between proponents of traditional market-cap weighted indexing and those that espouse alternative weighting schemes, the EDHEC-Risk Institute is venturing further into the fray as it prepares to launch a series of indices that seek the advantages of existing smart beta methodologies while managing some of their inherent risks.

In previous articles we have examined the broad characteristics of alternative weighting strategies. Critics of smart beta often make the observation that many such approaches create biases. Fundamental indexing, for instance, typically tilts portfolios towards small (or relatively smaller) companies and value stocks. It’s not hard to see why that might be the case: whereas market cap indices are heavily influenced by the largest companies and those whose shares have appreciated as a result of optimistic growth prospects, smart beta strategies often sell themselves precisely on the idea that they represent an alternative to that.

The existence of such biases is no small revelation. Small- and mid-cap stocks have historically been riskier than large caps, and value stocks may go through prolonged periods of under appreciation and underperformance relative to their more growth-oriented peers. As part of what it is calling “Smart Beta 2.0,” EDHEC is trying to refocus the smart beta discussion onto these types of risk. For example, if a certain fundamental indexing strategy displays a bias towards small cap value stocks, EDHEC essentially asks the question of what would happen if we tweaked that methodology by starting with a universe of only large, growth companies and then running the same model. If other smart beta strategies tended to overweight certain industries, similar tweaks could reduce the tracking error of such strategies by starting with sector neutrality and only then letting the model select stocks to fill each industry bucket.

The idea itself is not entirely new; other smart beta index providers may already accomplish these things to some extent through an initial filtering process. Moreover, some investors may like having a small cap, value bias. But EDHEC’s point is that if you’re an institutional investor you should be aware of those risk factors and be able to choose which ones you want to take. At present, we can’t really judge the full potential or natural efficacy of a smart beta strategy; we can only look to the results of particular commercially-available smart beta indices where those decisions have been made at the provider level. 

EDHEC intends to offer full transparency on its indices’ methodologies and daily constituents, which means that in theory, an investor or fund provider could replicate them on their own, without licensing EDHEC. In practise, onlookers may prefer to wait and see how the indices perform. 

In the long run the indices will be judged by their performance relative to objectives and expectations. As with other smart beta strategies, EDHEC’s models derive their “smarts” by looking at historical data, and while they may backtest well, continued strong performance will depend on historical relationships holding into the future, which is by no means guaranteed. In fact, since smart beta has now been widely discovered, it’s quite possible that tomorrow’s environment will be different precisely because assets are flowing into models like these. Different smart beta indices will have different methodologies, but often offer variations on a theme. Models built to pursue strategies like minimum variance or maximum Sharpe ratio will be drawn to similar types of securities because of certain historical characteristics they exhibit. The sudden popularity of these securities, because of how they fit into quantitative models, may end up robbing them of their prized traits. 

That said, smart beta strategies in general, including the new variety from EDHEC, occupy an intriguing area between active and passive management, often combining the best parts from both. They are likely to take market share from the incumbents in each camp.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

About Author

Alastair Kellett

Alastair Kellett  is an ETF analyst with Morningstar Europe.

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