For several years Towers Watson has been investigating the use of smart beta investing across a range of traditional and alternative asset classes. The initial focus of the smart beta concept was in the equity space, where different approaches to constructing a passively managed portfolio were developed. Since then strategies have been developed in other asset classes as institutional investors turn towards more cost-effective and diversified solutions.

Where does 'smart beta' fit?
In a portfolio of mainstream, liquid asset classes – principally equities and bonds – we refer to the return achieved from tracking a benchmark or market index as ‘bulk beta’, where the benchmark follows a conventional market capitalisation approach to weighting underlying securities. Alpha represents the above-benchmark return that relies on the skill of active managers to generate and can be both capacity-constrained and expensive. In between bulk beta and alpha, lies smart beta as shown in figure 1.

Figure 1: The alpha/beta continuum and example approaches

In defining and applying the smart beta concept, we suggest a framework in which we split beta strategies between bulk beta (which does not need skill) and smart beta (which needs more skill in pragmatic understanding, implementation and rebalancing). In this framework, smart beta offers a range of strategies. We can group these strategies into three main types:

  • Diversifying beta – which exploits alternative exposures that are difficult or expensive to access and/or illiquid in nature. Example approaches include listed infrastructure and commodities futures.
  • Thematic beta – which exploits themes that are long term in nature where mispricing exists when many investors are focused on the short term. Example approaches include emerging wealth such as emerging market currencies and sustainability such as specialist funds with green/clean theme.
  • Systematic beta – which exploits security weighting methods that deviate from conventional market capitalisation approaches and take advantage of opportunities arising from factors such as behavioural biases and systematic mispricing of securities. Example approaches include value-weighted indices and low- or minimum-volatility indices.

To believe in the smart beta proposition, one must first accept that there is a wider framework than the narrow definitions of alpha and beta which classic finance theory puts forward. Therefore, a wider definition of alpha includes choice of smart beta and skill in alternative investments, whereas the narrower definition includes the classic active management approach, which generates returns from skill to outperform the market cap-weighted indices by security selection or tactical asset allocation decisions.

What are the key benefits from the use of smart beta?
Smart beta strategies are considered relatively simple approaches to doing existing beta better or creating exposures to investment ideas or themes, but at a lower total cost than alpha. In our view, the inclusion of smart beta strategies in a portfolio can enhance overall portfolio efficiency through better risk-adjusted returns or improved portfolio diversity over the long term.

A smart beta strategy may have one or more of the following features, as previously highlighted in figure 1:

  • it captures a premium for taking on risk previously only available through expensive alpha strategies that can be reproduced in a cheaper way;
  • it applies long-term investment themes with simple and transparent strategies;
  • it shifts from a pure market capitalisation approach to alternative ways of weighting securities according to a particular characteristic, style or risk factor – for example, equities with low volatility.

Figure 1 also shows that this wider alpha/beta framework hinges on building investment strategy as a combination of certain return-drivers. Examples of possible return drivers that are closely linked to risk factors include equity, credit, term, inflation, currency, illiquidity and insurance. One further return-driver is ‘manager skill’ – access to individuals and organisations that can produce returns in excess of agreed benchmarks. Investors can access to a wider spread of return drivers through the use of smart beta in portfolio construction.

However, no single smart beta idea works in all market conditions. It is important for investors choosing among smart beta strategies to understand the economic rationale behind these return drivers, which can either be temporal, with a finite term, or secular and largely timeless.

What are the challenges that investors face when trying to exploit smart beta ideas?
While we advocate smart beta strategies as a new avenue for many institutional investors, it is essential to be aware of (some but not a lot of) additional governance required to evaluate and monitor the smart beta strategies over time, as these strategies require more skill than that of bulk beta. Perhaps the toughest challenge faced by investors is the overwhelming variety of products that have sprung up in recent years. We believe there are often 'devil in the detail' challenges when evaluating these products in terms of their simplicity, transparency, ease of understanding and cost.

Therefore, the smart beta ideas may not be for everyone. Whether smart beta strategies should form part of the investor’s portfolio depends on its existing governance and investment arrangements. At Towers Watson, we take a holistic approach in considering which smart beta approach(es) would be appropriate for each client – for example, how an existing portfolio is constructed, its overall objectives, risk constraints, investment beliefs and alignment with its governance.

If you wish to discuss any of the approaches to implementing smart beta in more detail, please get in touch with the consultant who normally advises you at Towers Watson, or:

Naomi Denning, managing director of investment services for Asia Pacific

The contents of this article are for general interest. No action should be taken on the basis of this article without seeking specific advice.

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