Getting to grips with rules-based strategies

The name itself raises questions: is it truly smart or beta? In addition, for some investors smart beta is a passive strategy, while for others it’s an active one – so which is it?

Beta is a concept that describes the risk and return characteristics of a particular asset class or portfolio. As a term, it’s synonymous with the entire market.

Indices that track the market are traditionally weighted by market cap. This way the index represents the market, reflecting all of its securities as well as the combined wisdom of all investors in terms of the prices they have set.

Smart beta describes weighting schemes that operate on rules-based methodologies and will tend to offer alternative exposure to risk factors compared with a market-cap-weighted index.

These strategies evolved after large-cap and growth stocks performed badly in the bear market of 2000-02, and investors began seeking alternatives.

One of the problems with defining smart beta is that there are many different types of strategy with various investment objectives.

For example, a low-volatility weighting scheme prioritises stocks from companies that demonstrate stable returns in comparison with the market. Value investing is also a popular smart beta strategy that focuses on stocks perceived to be trading at a discount.

Many other criteria exist, such as momentum, GDP or dividend payout, and they can either be used as the sole basis for weighting an index or portfolio, or used in combination with other factors.

But even strategies that combine several factors will not match a market-cap view of the market, which captures all possible factors that investors collectively use.

While there is no single definition of smart beta, what these strategies have in common is divorcing market cap from a security’s weight in an index or portfolio. As beta means the whole market, smart beta isn’t really beta as it doesn’t attempt to replicate it.

So is it active or passive? The first thing to consider is that from the outset, a decision to deviate from market cap is made, meaning that active risk is assumed.

Investors in smart beta strategies are no longer buying the market as a whole. Instead, they are following rules-based strategies that involve an active decision. Accordingly, smart beta funds display higher active shares than index funds, so smart beta is an active, rules-based strategy.

Let’s look at a typical value-weighted strategy. You’d expect it to focus on value stocks to the detriment of non-value stocks. This will probably mean the portfolio itself will be smaller, with a less diverse range of countries and industries than the broad market. Investing in certain areas of the market to the exclusion of others is an active decision.

Investors in smart beta strategies are likely to find that their returns will differ from the broad market.

Furthermore, the strategies may not be as effective as expected for capturing the factor risk premium. Our research shows that non-market, cap-weighted indices have dynamic risk exposures, meaning that at any point in time an investor’s exposure to, for example, value equities may be greater or less than assumed by the strategy.

Investors need to consider the size of these deviations given market cyclicality and their tolerance for any periods of potential underperformance.

Smart beta funds can offer investors an array of opportunities. But it’s important to remember that although these funds are marketed as beta, they do not represent the whole of the market. They will inevitably slant a portfolio’s returns away from the market, and that may be fine as long as investors understand the different active risks they are taking.

Peter Westaway is chief European economist at Vanguard