Smart beta is a frustrating term. Beta is volume multiplied by value, or in equity terms, shares outstanding multiplied by price per share. It is hard to see how it can be smart or dumb. It is just the whole market.
This is not just an academic exercise in terminology. An index fund is passive insofar as it is market capitalisation weighted, when the securities in the index are weighted by their overall value so that it replicates the market. Any step away from that market cap weighting is a step away from the market, away from beta. It can be smart or dumb depending on your point of view, or the outcome of your investment. But it is always active because it requires an active decision.
Why do we need to know this? Indexing has become so widely accepted in recent years that it has led to a proliferation of benchmarks and fund choices, but not all of these are passive. This has generally been a benefit to investors, as it has meant access to lower-cost, simpler products. It has also led to much greater interest – or competition – in how the rules-based principles of indexing might be applied to a broader range of strategies.
According to Vanguard calculations, from a handful of passive index funds available 15 years ago, there are now some 200 passive (market-cap weighted) index funds and a further 250 alternatively weighted or ‘active rules-based’ funds. Product providers, though, have been significantly more enthusiastic than investors, as only about $1.7bn (£1.1bn) has flowed into active rules-based funds compared with around $1.3trn in market-cap index funds.
Factor funds are the most common form of active rules-based funds. This might be because factors have been around for a long time. Value investing, for example, is widely known and was originally documented as far back as the 1930s. It essentially targets the ‘value’ factor – companies that appear inexpensive when compared with the specified metrics. Other equity market factors include capitalisation, momentum and volatility. Factors exist in bond markets too. The tendency for long-dated bonds to earn a ‘term premium’ over short-dated bonds is one such factor. The credit factor is lower credit quality bonds outperforming bonds of higher credit quality.
Why is there now so much interest in this variety of alternatively weighted strategies? In part, as the fund flow data suggests, in a crowded and competitive market, product providers have been keen to offer new strategies. But there is another reason, which is that active rules-based strategies have tended to outperform the market over the past 15 years.
Looking at the period 31 December 1999 to 31 December 2014, the MSCI World Index had an annualised return of 3.9 per cent and an annualised volatility of 15.87 per cent, giving an annualised risk-adjusted return of 0.25. The risk-adjusted return for the MSCI Minimum Volatility Index, by comparison, was 0.62. For the MSCI World Risk-Weighted Index it was 0.65 and for the MSCI World Equal-Weighted Index it was 0.46. Of these three alternative indices, only the Equal-Weighted had greater volatility, at 17.2 per cent.
Given such results, is there really an argument? If an active rules-based strategy can offer lower volatility, better returns, and the low cost and transparency of an index fund, they surely have a big future? Forgive me if I answer yes and no.
The outperformance of any particular factor-bias is far from absolute. Outperformance over the past 15 years is best explained by the specific risk exposures of existing benchmarks, particularly value and size (small cap), which have done well over the test period. Taking the data back another 10, or even five years, might yield very different results.
The point is that risk factors are dynamic relative to the broad market. Relative performance will therefore always be cyclical. There may also be unintended risks. For example, a low volatility portfolio is likely to find its holdings concentrated in defensive industries, such as food manufacturers or pharmaceuticals. Even a supposedly simple value fund can have hidden complications. What, for example, is the best metric; price-to-earnings, price-to-book, price-to-sales or price-to-cashflow?
There is nothing wrong with these tilts, as long as investors understand that they amount to an active decision and are prepared for the potential outcomes. There will be times when factors outperform and times when they underperform. Investors need to understand that an active rules-based strategy is not a guarantee of a smooth journey. They need to be confident that the risks and returns from their choice of strategy will help them meet their long-term investment objectives.
Peter Westaway is chief economist and head of investment strategy group for Europe at Vanguard Asset Management.