The (not so) new world of smart beta

Smart beta strategies are an area of investing receiving significant attention in the past few years. These strategies focus on exposure factors that have historically had an impact on investment performance. By systematically and deliberately setting exposure factors such as momentum, quality, or value, managers can utilize smart beta strategies to improve returns, reduce risk or enhance diversification.

An established concept

The idea behind smart beta has been around for some time. In the early 1990s, Eugene Fama and Kenneth French conducted research and identified companies with two factors or characteristics that appeared to have a positive effect on returns:

  • Smaller size
  • Value in terms of price to book

Since Fama and French’s initial work, other factors that have been identified include dividend growth, size and volatility. Currently, assets in smart beta strategies total approximately half a trillion dollars or approximately one-quarter of all ETF assets.

Smart beta is more than just factors

Smart beta strategies look at other areas that can affect returns that can also be at least partially controlled, particularly expenses. ETFs are typically less expensive than traditional mutual funds. Cheaper investments can translate into greater returns for investors. This represents a substantial shift from the old paradigm of active management, which sought to add returns through market timing and individual security selection.

The best of both worlds?

Smart beta mixes elements of low cost investing and both active and passive investing into one strategy, trying to add to returns. It uses more cost-effective investment vehicles, which is often associated with passive investing. Some of the characteristics of indexing are also used, but smart beta “actively” uses rules and standardized guidelines to deviate from market cap weightings to provide exposure to potentially higher returns. For example, a value-oriented smart beta strategy will invest more in what should be undervalued stocks and less in overvalued stocks. This is something an active value manager also seeks to do, but smart beta does it in a systematic manner and more cheaply.

A good time to use smart beta

We believe that there is a high level of uncertainty ahead in the markets, with volatility likely to be higher and returns lower. Smart beta strategies, which focus on exposure to factors, variables that can be controlled and expenses, may be well suited for navigating the type of market that we are currently encountering and anticipating.

Active management still plays a part

While smart beta strategies can provide important benefits in improving returns, reducing risk and/or enhancing returns, we are not advocating for smart beta to take the place of active management. We consider an allocation to smart beta as a systematic way to access those factors that have historically had a positive impact on returns. When we believe that active strategies make sense on a risk-adjusted return basis, we will use active management.

Why smart beta works

There is considerable discussion why smart beta works. One argument is that asset classes are exposed to systematic risks in the market which diversification cannot eliminate. Therefore, to attract investors, the risk must be compensated for through excess returns. Value and momentum exposure factors are highly sensitive to the macroeconomic environment. This risk results in a positive return premium being offered to attract funds.

Other proponents of smart beta cite the irrational behavior of investors as the main support for factor-based investing. For example, investors repeatedly chase winners (buy high), which causes them to repeatedly and systematically make investment mistakes. We believe such biases will continue to prevail, boding well for factor-based investing.

Short-term bumps may occur

While evidence points to the success of factor-based investing over the long-term, we do caution that there is cyclical behavior associated with smart beta. There have been periods of time when exposure factors can, and have underperformed the market, such as dividend growth stocks over the last four years. For investors with a long-term investment view and horizon, we believe that an allocation to smart beta strategies can provide attractive risk-adjusted returns.

The material presented in this article is of a general nature and does not constitute the provision by PNC of investment, legal, tax, or accounting advice to any person, or a recommendation to buy or sell any security or adopt any investment strategy. Opinions expressed herein are subject to change without notice. The information was obtained from sources deemed reliable. Such information is not guaranteed as to its accuracy. You should seek the advice of an investment professional to tailor a financial plan to your particular needs. For more information, please contact PNC at 1-888-762-6226.

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Important Legal Disclosures and Information

The material presented in this article is of a general nature and does not constitute the provision by PNC of investment, legal, tax, or accounting advice to any person, or a recommendation to buy or sell any security or adopt any investment strategy. Opinions expressed herein are subject to change without notice. The information was obtained from sources deemed reliable. Such information is not guaranteed as to its accuracy. You should seek the advice of an investment professional to tailor a financial plan to your particular needs. For more information, please contact PNC at 1-888-762-6226.

The material presented in this article is of a general nature and does not constitute the provision by PNC of investment, legal, tax, or accounting advice to any person, or a recommendation to buy or sell any security or adopt any investment strategy. Opinions expressed herein are subject to change without notice. The information was obtained from sources deemed reliable. Such information is not guaranteed as to its accuracy. You should seek the advice of an investment professional to tailor a financial plan to your particular needs. For more information, please contact PNC at 1-888-762-6226.

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