By: Bernisha Lala, Head of Indexation at Old Mutual Investment Group
If you’d rather avoid the never-ending debate between active and passive investing but recognise the value in combining elements of both worlds, then look no further because there’s a solution for you. Enter the world of “smart beta” or factor investing, a strategy that has gained considerable attention since its emergence in the early 2000s. While it draws inspiration from the pioneering work of American economist Harry Markowitz (initially formulated in the 1950s) and his contributions to modern portfolio theory, smart beta represents a unique approach in the current financial landscape, with significant influence from the work of Eugene Fama, Kenneth French introduced in 1992), and Mark Carhart (introduced in 1997) and their factor-model theory.
In today’s economic climate, marked by heightened volatility, the looming possibility of a recession in the United States, and persistently low returns, smart beta investing stands out as an attractive option. This approach aims to provide investors with the advantages of both passive and active investment strategies.
The primary goal of smart beta is to achieve alpha in a systematic manner. Alpha refers to excess returns beyond what would be expected based on a strategy’s beta exposure. Simultaneously, some smart beta strategies seek to mitigate risk and enhance diversification—all while maintaining costs lower than traditional active management and only marginally higher than pure index investing. This innovative approach blends elements of the efficient-market hypothesis and factor or style investing to construct an optimally diversified portfolio, drawing on the Fama-French and Carhart factors as key components. Smart beta strategies are applicable across a wide range of asset classes, including equities, fixed income, commodities, and multi-asset classes.
At the core of smart beta lies the application of a rules-based investment process to create portfolios that can be run systematically. The objective is to achieve long-term asset growth by selecting, weighting, and periodically rebalancing securities based on predetermined factors constructed from fundamental, sentiment and market metrics.
When it comes to smart beta, there is no one-size-fits-all approach. Investor objectives can vary widely. For instance, equity-focused smart beta strategies aim to address inefficiencies associated with market-capitalisation-weighted benchmarks. Some funds adopt approaches, focusing on mispricing created by investors seeking short-term gains, while also considering the momentum factor highlighted by Carhart for example.
Managers may opt for alternative weighting schemes based on fundamentals or economic size of companies, where investments are based on metrics like earnings or book value rather than market capitalisation. Another approach involves risk-weighted smart beta, which relies on assumptions about volatility, considering historical performance and correlations between risk and return.
As an example, Old Mutual has embraced the smart beta philosophy through its FTSE RAFI® All World Index Strategy. This strategy seeks long-term asset growth by selecting and weighting securities based on fundamental measures of company size, rather than market capitalisation. It employs metrics such as sales, book value, cash flows, and dividends to quantify a company’s economic footprint. The RAFI methodology allocates more to undervalued companies and less to overvalued ones compared to traditional market capitalisation-weighted indices. Mean-reversion benefits investors when undervalued companies rebound or overvalued ones revert to fairer levels, aligning with the principles of Fundamental Indexation®.
Old Mutual’s strategy combines the benefits of rule-based frameworks, drawing from traditional index approaches and systematic techniques. This approach offers the advantages of passive investing, which include transparency, objectivity, cost-efficiency, broad economic representation, and diversification. Moreover, it provides systematic alpha exposure through embedded smart beta methodologies.
While smart beta investing holds the promise of improved returns and risk mitigation, it’s crucial to recognise that there are associated limitations. These limitations could encompass heightened tracking error, exposure to market timing risks, and factor exposures that may not align well with prevailing market conditions. Consequently, it is imperative for investors to conduct comprehensive due diligence and thoughtfully assess their financial objectives and risk tolerance when scrutinising smart beta strategies.
In conclusion, smart beta investing stands as a compelling alternative to traditional passive and active investment strategies. It combines the potential for enhanced returns and risk management, offering investors a balanced approach at an efficient cost. The practical implementation of smart beta principles, exemplified by Old Mutual’s FTSE RAFI® All World Index Strategy, underscores the transparency and efficiency that investors seek in achieving their long-term financial objectives. As the investment landscape continues its evolution, smart beta strategies are poised to play an increasingly prominent role in shaping the future of finance.