What’s in a name?

It was selected to describe a way of investing based on different rules apart from following generic indexes that are weighted according to the market capitalisation of the companies listed.

The concept was forged in the 1990s, by Chicago Booth professors Eugene Fama and Kenneth French, who designed a three-factor model of investing looking at company size, company price-to-book ratio, and market risk.

Professor Carhart added ‘momentum’ to the model and gave investors four ways of assessing an investment.

Based on this, academics contemplated a way of using these and other models to create a way of getting better returns by exposing portfolios to these different risk factors. Hence Bryon Lake, head of Invesco PowerShares EMEA, says: “Smart beta originated in academia”.

Ben Seager-Scott, director of investment strategy at Tilney Bestinvest, calls it a “marketing-derived term promoted very heavily by a certain group with deep marketing pockets. Smart Beta is an umbrella term for a range of strategies”.

Whether from academia or marketing, ‘Smart Beta’ has entered the retail investment space – but as Chris Mellor, executive director, equity product management at Source explains, there is “still no standard definition – it is a catch-all term for a diverse group of funds”.

Those against the term ‘smart beta’ argue this implies passive, market cap-weighted strategies are not an intelligent choice Vivian Tung

In fact, several firms tend to avoid using ‘Smart Beta’ altogether. Index creator Nasdaq Indices sees smart beta as “a rules and selection-based index methodology that drives to a particular outcome”, according to Dave Gedeon, vice-president and head of research and development.

Tilney Bestinvest prefers ‘alternative beta’, Novia Financial likes ‘rules-based investing’; Deutsche Asset Management calls it ‘strategic beta’.

Martin Weithofer, head of strategic beta at Deutsche Asset Management, says: “Smart beta is not the most accurate term.

“We call it strategic beta because it’s about implementing a strategic investment strategy in a passive way. It still tracks an index but with a different type of risk and reward performance to traditional cap-weighted indexing.”

The term could also be considered rude in some circles. Vivian Tung, vice-president, BBH Exchange Traded Fund Services, comments: “Those against the term ‘smart beta’ argue this implies passive, market cap-weighted strategies are not an intelligent choice.

“This is one reason why other terms such as alternative beta or strategic beta are becoming more popular’.

Nomenclature aside, what about the definition? What is such a strategy and what does it do?

Even this, according to Mr Seager-Scott, is “still the subject of debate”. Essentially, Smart Beta – which is the term we’ll use for the purposes of this guide – covers a range of strategies that enable the investor to invest passively, in an index, but the index itself has been constructed in a certain way to provide a different exposure.

So rather than invest in the FTSE 100 and have one-third of the portfolio automatically weighted to the top 10 stocks by market capitalisation, an index provider could create an equally-weighted index, so that each stock occupies 1 per cent of the portfolio, thereby avoiding any size-based performance bias.

As Ms Tung explains: “Smart beta products eliminate systemic biases in traditional indexing products by weighting securities based on other fundamentals”.

These fundamentals can include:

■ Cash flow

■ Dividends

■ Sales

■ Equal weighting

■ Volatility.

These can be called ‘fundamentals’ or ‘factors’ or ‘tilts’ or even ‘style’ – but basically these rules will be applied to the construction of an index, or an index-tracking product such as an exchange-traded fund. Says Eric Shirbini, global product specialist for ERI Scientific Beta, “Smart beta is an index constructed with clearly defined and transparent rules”.

The rules might be transparent – but there are many ways of writing the rules for a smart beta product. As Mr Seager-Scott predicts: “As the industry grows, you could well see as many different types of smart beta as you do styles with active managers – if not more.”

So there are different names for Smart Beta, and it covers different investment strategies using different methodologies or investment rules. But what practical function is there for such a catch-all investment?

Mr Mellor says: “Smart Beta usage can be grouped into two categories: funds which aim to isolate a specific segment of the market and funds which are more diversified.

“Funds falling into the first category would be expected to outperform the broad market in certain conditions, but underperform in other conditions. So investors would tend to use those types of smart beta funds in a tactical way, as ‘tools’ to tilt their portfolios.

“The latter are what we would call strategies, and they would aim to outperform the market during different conditions. They may be more suitable as long-term holdings.”