By Thomas Reif

Smart beta is attracting increased interest as investors find they may no longer be able to meet their desired outcomes using traditional investment approaches. In an environment of potentially extended low and slow growth, and increased uncertainty, many investors are considering rethinking how they build portfolios. Smart beta gives them the opportunity to potentially achieve higher returns than the traditional market-cap benchmark over time and / or lower risk using cost-efficient implementation strategies.

A rules-based approach can be disciplined and effective in harnessing specific attributes of risk and return, known as “factors” to try to generate better risk-adjusted returns, a style typically used by active managers. Investors who are also looking for cost efficiency, greater transparency and consistency — attractive features of passive investing — may find smart beta more suitable for their needs because it offers active-like investing within a relatively low cost, passive-like structure.

What investors should consider

The chart below shows how indices tracking six main, broadly accepted equity factors performed against the market cap-weighted benchmark (MSCI World Index) over the long term. It’s worth noting, however, that there have been periods when certain factors underperformed the broad market while others outperformed.  

That’s why when it comes to smart beta investing, we believe the first thing an investor needs to decide is which factor to capture in a portfolio. Factor selection should be influenced by the investor’s risk preferences and should be aligned with his or her investment goals. Below we briefly outline the most common smart beta factors that drive portfolio returns: 

  • Value: Value stocks are those that trade at a low price relative to their fundamentals, such as earnings or sales. Value stocks have been shown to outperform the broader market indices over the long term. These results have been replicated by numerous researchers over many different sample periods and for most stock markets around the world.2 Possible explanations of excess returns include investors’ behavioural biases and the reward for taking additional risk or providing liquidity in a stressed environment. 
  • Quality: This factor focuses on companies with low debt, stable earnings and high profitability. Higher quality companies seem to be rewarded with higher returns over the longer term because they have been shown to be better at deploying capital and generating wealth than the broader market.3
  • Size: Small-cap stocks have tended to outperform their large-cap peers over time.4 Some of the outperformance of small-caps can be attributed to the fact that fewer analysts typically cover these companies, giving them the potential to surprise the market to the upside because there is less visibility into their operations. Another argument for their long term outperformance may be that they are higher risk than their large cap brethren.
  • Low volatility: Volatility—or the standard deviation of past returns—is one measure of risk. The long-term historic outperformance of low volatility strategies may appear to be at odds with more traditional financial theory, but empirical evidence suggests otherwise.5 One explanation for this outperformance is that investors overlook “boring” low volatility stocks in favour of “glamorous” ones—such as popular tech stocks —and, in the process, miss out on the consistent returns low volatility stocks can offer.
  • Momentum: Empirical evidence shows that stocks that have done well recently may have greater potential of doing well in the near term than the broader market.6 Obtaining more exposure to these stocks could potentially result in a portfolio benefitting from the momentum premium. 
  • Yield: Over the long term, stocks with higher dividends tend to perform better than stocks with lower yields.7 This outperformance could be attributable to the Value or Quality characteristics of yield.

At the end of May 2017, there were 1,237 smart beta equity exchange traded funds (ETFs) and exchange traded products (ETPs) globally, with US$585 billion in assets.7 With a growing number of smart beta strategies now offered in Australia, investors should conduct ample due diligence before choosing a smart beta fund. Not all smart beta funds are created equal, so knowing what lies beneath the label can assist investors to make better decisions on when, how, and why they may want to implement smart beta within a portfolio. Investors should work with their financial adviser to find the right strategy for their individual risk tolerance level and objective 

1)“The cross-section of expected stock returns,” Fama, E. & French, K., Journal of Finance, as of 6/1992, 47, 427 – 465. Fama, E., & French, K., “Common risk factors in the returns on stocks and bonds,” Journal of Financial Economics, Volume 33, issue 1, as of 6/1992, 3 – 56
2)“Do Stock Prices Fully Reflect Information in Accruals and Cash Flows about Future Earnings?” Sloan, R.G., The Accounting Review, as of 1996, 71, 289 – 315
3)“The cross-section of expected stock returns,” Fama, E. & French, K., Journal of Finance, June 1992, 47, 427 – 465; Fama, E., & French, K., “Common risk factors in the returns on stocks and bonds,” Journal of Financial Economics, Volume 33, issue 1, as of 6/1992, 3 – 56
4)“Low Risk Stocks Outperform within All Observable Markets of the World,” Baker, Nardin and Haugen, Robert A., as of 4/27/2012
5)“Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency,” Jegadeesh, Narasimhan and Titman, Sheridan, The Journal of Finance, Vol. 48, No. 1, as of 3/1993, pp. 65 – 91
6)“Stock Returns and Dividend Yields: Some More Evidence,” Blume, M.E., The Review of Economics and Statistics, 1980, 62 (4) 567 – 577
7)ETFGI, as at 27/06/2017

This is a sponsored article from State Street Global Advisors.

Issued by State Street Global Advisors, Australia Services Limited (AFSL Number 274900, ABN 16 108 671 441) ("SSGA, ASL") This material is of a general nature only and does not constitute personal advice. It does not constitute investment advice and it should not be relied on as such. It does not take into account your individual objectives, financial situation or needs and you should consider whether it is appropriate for you. You should seek professional advice and consider a products disclosure statement, before making an investment decision. ©2017 State Street Corporation —All Rights Reserved. AUSMKT-3812 | Expiry date: 31 August 2018.