Jargon Busting: Smart beta

Jargon Busting: Smart beta

We live in an oxymoronic world.

Common sense is definitely not that common, social networks are decidedly anti-social, and I can’t think of anything less ‘smart’ than my so-called smart TV.

This week we size up ‘smart beta’.

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We touched on the general concept of beta a few weeks ago, but for the latecomers at the back here is a brief revision.

Beta is a measure of the amount a portfolio (or share or fund) rises or falls relative to the wider market, the usual proxy being a capitalisation-weighted index, such as the FTSE 100 in the UK or the S&P 500 in the US.

‘Beta investing’ is thus the passive investment strategy of tracking an index and earning the return of the market, as opposed to trying to beat it.

Making beta investing ‘smart’ simply means choosing to track an index that’s actually worth tracking.

Consider that capitalisation-weighted indices will, by nature, assign lower weights to undervalued stocks and higher weights to overvalued stocks. This runs afoul of sound investment sense.

Instead of weighting stocks by size, what about weighting stocks by dividend yields or price-to-earnings ratios?

Instead of favouring the largest, what about favouring the most profitable or the least volatile? Smart beta is a broad-brush term to refer to systematically and passively tracking an index that is not capitalisation-weighted. If you think of ‘alternative index’ investment, you have got the nub of it.

You will notice this definition is opaque.

If you pick your 20 favourite stocks and equal-weight them – well, that arguably could be smart beta too. Needless to say, not all smart beta strategies are all that smart.

Indeed, the term is presumptive to the point of smugness.

Strategies based on back-testing over a relatively short time frame can produce results that turn out to be spurious. To test fully whether a quantitative strategy works, one must look back across various economic cycles and for very long periods (at least 50 years), and always ensure there is an economic rationale that can explain why the strategy should work.

If your back-testing reveals that companies with names starting with vowels are outperformers, something is not right.

Smart beta has opened up a world of specialist predilections, that of ‘factor investing’. If you decide you want to bias your portfolio to momentum, or to value, or to domestic or overseas earnings, or high growth or deep value, there will be a smart beta fund to fit every possible penchant.

But if all a landmine needs is a piece of ground and a man with a pick, a smart beta strategy needs only a spreadsheet and a set of rules.

To access smart beta you do not have to scour the lists of exchange-traded funds to find whatever is tickling your fancy, all you need is a screen and some strict rules.