Why investors employ smart beta strategies

The common view is smart beta is used to side step expensive active equity managers or hedge fund managers whose processes are on the surface opaque, but on close investigation turn out to be largely beta like in approach.

As investors have gained experience and familiarity they have also learnt about how it offers greater granularity of approach, by offering investors access to different kinds of risk premia many of which can be used in a tactical way.

The A$53 billion Sydney-based First State Super has used smart beta to get exposure to particular risk factors that were attractive at a point in the investment cycle or to manage exposure to a particular asset class or sector where the fund might want exposure or to avoid an exposure.

Michael Blayney, head of investment strategy at First State Super, says there is a whole skill set in combining factors. He cites the example of how combining a quality portfolio and a value portfolio might produce a sub-optimal outcome, compared to buying the value portfolio with a quality filter because the factors can combine in a nonlinear way.

“There are so many different risk premiums you can extract, extracting just one in a very simplistic way is probably not going to be the optimal way to do it,” he says. “If however you are looking to do something which perhaps complements the rest of your portfolio, then it can make a lot more sense depending on what resources you have, either partnering with an asset manager to build it in-house yourself,” he says.

The timing of an investor’s entry into a factor needs to be considered.

“You can look at whether a portfolio of stocks trades at a premium or a discount compared to how it trades relative to the market through history,” he says. “So you can get a feel for whether you are overpaying for something that’s popular or not.”

On this point, Blayney seeks to make a distinction between the times an investor would use a tailored smart beta portfolio and when it would not.

“If you just want a short term tilt on value, then picking an off the shelf index and implementing that makes a lot of sense,” he says.

So after implementing such smart beta strategies what does success look like for an investment team? Certainly this is the case if a smart beta portfolio gives the same return as the index with a much smoother journey revealing itself to have a superior sharp ratio. However, other factors may naturally come with a higher volatility than the index and here an investor would need higher compensation than what the index returns. Other benchmarks of success might be outperforming in down markets or simply delivering better diversification.

Measuring this outperformance is problematic because a risk premium can take 10 years to manifest itself and be observable. “These things can underperform for a long period of time,” warns Blayney.

This all hints at how hard it can be to explain the decision making process of smart beta compared to say, a fundamental equity manager.

“[To explain how a fundamental equity manager works is] very easy and very intuitive. You can talk about the companies and their earnings,” he says. “But when you go and try to explain a smart beta strategy to somebody, you start talking to them in terms of risk premia and factor exposures. It is actually far more difficult to communicate that.”

The A$33 billion Sunsuper is another investor with experience of smart beta or factor investing as it prefers to call it. It has used the style to overcome a large factor bias in certain indices, as a means of reducing fund management costs where it has lost faith in active management but not in a particular factor.

For Joshua Bloom, portfolio manager for international shares at Sunsuper, timing is key in entering a factor in terms of its price.

For Bloom, this places a large emphasis on the decision of the investor to make the decision to allocate – poor performance could not be blamed on a lack of skill by the manager.

“If you’re the one that’s selected a factor or premium that for whatever reason is not working, it’s not the manager’s fault anymore,” he says. “Whereas now the decision is solely the asset owners or the board or whoever is making the decision.”

This article are taken from a round table discussion hosted by conexust1f.flywheelstaging.com’s sister publication, Investment Magazine, on smart beta undertaken by Australian investors, consultants and Goldman Sachs Asset Management.