By Peter Westaway
Despite the proliferation of products and growing investor interest, there is no consensus definition of smart beta. These strategies don’t seem to fit into clear cut categories. Are they really beta? Are they really smarter than the market? Are they really passive or actually active?
What is beta?
Traditionally, the term beta describes the risk-and-return attributes of a particular asset class. It’s a natural starting point when you think about how to represent that asset class. But beta is a theoretical concept; you can’t invest directly in it. So we have indices to represent beta, and passive investors can invest in funds that seek to track those indices. Beta is now synonymous with the market for a particular asset class.
The market is all the securities within the asset class priced to reflect the aggregate knowledge and wisdom of all investors. As a reflection of the market, beta is neither smart nor dumb. It just is. To truly represent the market, an index must be weighted in a way that reflects this aggregate wisdom – which is by market capitalisation.
So what is smart beta?
Definitions of smart beta vary widely depending on who you ask. A survey that Vanguard commissioned yielded definitions including “low-cost alpha”, “part of the evolution of indexing” and “higher-cost indexing”. Finding a meaningful and succinct definition isn’t helped by the wide range of criteria different smart beta strategies use. These include value, volatility, dividends, economic growth, trading volumes or a combination of these or many other characteristics.
However, there’s a common denominator. The strategies deviate in some respect from a market-cap-weighted benchmark. They typically apply rules for selecting investments and for weighting securities in a portfolio. Tapping into this rules-based approach, index providers have created indices reflecting these strategies. Investors choosing to track these indices may consider it passive investing. But I would argue that the decision not to weight by market capitalisation – which, remember, reflects the market’s composition at any given time – is an active decision, and not a way to arrive at beta. Whatever their makeup, these alternative weighting schemes have characteristics that should lead to performance that differs from the market’s risk-return characteristics, or market beta.
Not passive, but active
The decision to invest in such strategies is therefore a decision to invest actively. Some of these strategies have outperformed their market-cap-weighted counterparts over the last 15 years. But our research shows that this is primarily explained by systematic tilts towards specific risk exposures of existing benchmarks introduced by the security selection process of non-market cap weighted indices.[1] They have essentially captured the effects of style (value) and size (small cap), which outperformed over the analysis period.
It’s also worth noting that such risk factors are dynamic relative to the broad market. Both small cap and value equities within a targeted broad-market benchmark have undergone periods of underperformance compared with the broad market. I’m not suggesting that such market deviations are unacceptable, only that investors need to consider the size of those deviations given the markets’ cyclicality.
This reinforces our belief that smart beta strategies should be considered active strategies. While the debate regarding the long-term performance of active versus indexed strategies continues, we believe re-weighting traditional market-cap indices represents neither a new paradigm of index investing nor a smarter way to invest.
Peter Westaway is chief European economist at Vanguard Asset Management
[1] The research findings discussed in this article can be found in ‘An evaluation of smart beta and other rules-based active strategies’ by CB Philips, DB Bennyhoff, FM Kinniry Jr, Todd Schlanger and Paul Chin (Vanguard, 2015).
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