What is Smart Beta? And why do we need it?
Smart Beta is a method to rebuild a portfolio with a weighting scheme different from the market capitalized weightage method. The weighting scheme can be based on fundamental factors different from size e.g. revenue, economic value etc. Most popular benchmarks today are built using the market capitalized method. The Asset Owners, Investors, and Asset Managers need Smart Beta because the industry needs a method to beat the S&P 500 and other market cap-weighted models. Why do we want to beat the S&P 500? Because S&P 500 is concentrated, hence risky, and buying more of the winner as it goes up is not the most efficient way to build a market benchmark or a portfolio. Everyone needs alpha i.e returns above the benchmark [above the S&P 500]. Alpha is a sign of intelligence and hence the need for a Smart Beta industry.
How is Smart Beta Constructed?
Smart Beta is an Apples to Apples approach, which means if the benchmark has 500 stocks, the Smart Beta portfolio has 500 stocks. Smart Beta is also designed as a low-frequency, slow, passive portfolio that has a similar risk to the benchmark. A Smart Beta on Dow 30 will have 30 stocks. A Smart Beta on commodities will have 22 commodities etc.
Why did early versions of the Smart Beta fail?
As a group Smart Beta manages 6 trillion USD today. And as a group it has failed to deliver alpha and proved not to be “Smart”. There are many reasons. The industry has conventionally focussed on fundamental factors instead of quantitative factors. Fundamental factors are known to persist and fail. Industry can not anticipate for the longer term whether Value as a style is going to beat Growth as a style or vice versa. Markets are complex and linear financial models can’t model non-linear markets.
Why now?
With early Smart Beta failures behind us, the industry has acquired more knowledge regarding the complexity of modeling fundamental factors. A secular bull market has seen factors falling in and out of favor. Growth emerged as a top factor in the secular bull market, till the momentum crash happened and raised a big question of the factor’s long-term consistency. Above this, the small investor revolution has seen a new generation of traders make and lose money and realize the value of the passive low-fee industry. New technologies have seen the emergence of new do-it-yourself ideas like Direct Indexing. Passive’s eventual takeover of the active industry also assists the Smart Beta innovation. Investor education makes it easier for the adoption of new Smart Beta approaches that can stand out of the crowd and deliver alpha. Markets will continue to innovate and zero-fee ETFs that charge only on Alpha create a large opportunity for the Smart Beta industry.
Figure 1: Weighted average equity ETF fee (%)
Source: Deloitte Performance Magazine
The New Smart Beta
Our Exceptional & Rich [E&R] Method is a Smart Beta method that is agnostic to the region, to the asset, to the mandate, and to the factor. Above that, it’s an open method that builds Indices. The differentiation of the E&R method from the rest of its peers is its nonlinear approach to markets. Our method assumes markets to be dynamic and uses statistical factors instead of fundamental factors. You can test and validate our method on our open Sandbox on GitHub.
Bibliography
1] All about, alpha, beta and smart beta, Fidelity Learning Center
2] Smart Beta – What you need to know, FINRA, August 2022
3] Arnott. R, What Smart Beta means to us, Research Affiliates, August 2014
4] Bruno. Florent, Will smart beta ETFs revolutionize the asset management industry? Deloitte, September 2021
5] Rabener. N, Smart Beta: Broken by Design?, CFA Institute, February 2019