Lipper Insight Review: A Look at Smart-Beta Funds

In this series of articles we look at smart-beta or enhanced-beta funds. In the current article we give an introduction to the subject. In subsequent articles we look at portfolio construction, the use of benchmarks, the various risks enhanced-beta funds carry, and the diversification benefits (if any) smart-beta funds have.“Smart beta” is a rather elusive term like many other terms—such as absolute return and others—used in the alternative investment space. Smart beta lacks a strict definition and is also sometimes known as advanced beta, alternative beta, or enhanced beta. Smart beta may best be understood as an umbrella term for rules-based investment strategies that do not use conventional market-capitalization (market-cap) weightings. Examples of alternative weighting schemes are to determine weightings using dividend yields or by using various risk-return parameters.

Builders and users of smart-beta funds criticize market-cap weighting schemes because—by their very nature—cap-weighted indices give the most influence to the largest companies as well as to any companies that happen to be overvalued. That’s a potential problem because these companies are the most likely to underperform the broad market over the long period.

Smart beta also refers to an investment style where the manager passively follows an index designed to take advantage of perceived systematic biases or inefficiencies in the market. Such a fund costs less than actively managed funds, since there is less day-to-day decision making for the smart-beta manager. Smart-beta funds, however, have higher trading costs than traditional passively managed funds (which seek to minimize those costs), so in comparison smart-beta funds are the pricier option.

Manufacturers of smart-beta funds have documented the superior performance of their respective approaches compared to traditional market-cap weighted schemes. In several articles and documents discussing smart-beta funds, however, the performance comparisons have fallen short of accounting for the exposure smart-beta funds have to standard equity risk categories such as value and small-cap. This lack has fortunately begun to improve. What manufacturers need to do next is to provide more transparency, i.e., provide the details necessary for a detailed understanding of the construction mechanisms of smart-beta funds.

Commercially available strategies are “bundles” of various methodological choices. Performance and risk analyses of such bundles do not provide a clear understanding of how the different parts of the methodology influence the overall investment outcome. And more often than not, there is little or no access to constituent weightings over the performance period and incomplete information on the exact construction method. This lack of transparency adds to the confusion about what is driving the performance of smart-beta funds.

As for the use of benchmarks by manufacturers, there are statements made about the neutrality of the benchmarks, but a close examination reveals there may be a bias in favor of a particular method.

In our next article we look at equity factor exposures and begin our discussion of the importance of stock selection to smart-beta methodologies.