Smart beta strategies have officially become the ‘hot new thing’ in the investment management industry. According to the Financial Times, the use of smart beta strategies has been growing by almost 30% per year since 2012, and assets in these strategies may surpass $1 trillion by the end of this year. Given this trend, it begs the question, “What are smart beta strategies and should B|O|S be investing in them?”

Smart beta strategies are defined loosely as passive strategies that use something other than market cap (price multiplied by shares outstanding) weighting to determine the weights of the securities in the portfolio. Conventional passively managed stock index strategies usually use market cap weighting because that is the methodology used for the index they are trying to mirror. The S&P 500 Index, for example, uses this method.

Smart beta strategies, on the other hand, typically use other methods to determine the proportion of each stock in the portfolio. For example, some strategies may buy stocks in equal proportions or use financial ratios such as price-to-earnings ratios to determine the proportion of each stock. Other strategies may be constructed to increase or decrease exposure to certain risk factors.

Although there are many different types of smart beta strategies, the goal across all the strategies is the same; to cost-effectively increase returns as compared to a conventional passively managed index like the S&P 500.

Not surprisingly, the investment companies that manage smart beta strategies are armed with research that suggests their methodologies would have outperformed conventional benchmarks in the past. Some of these strategies are based on rigorous academic research, but many are based on back tests of data of only 15 years or less. In these cases, it is hard to determine whether the outperformance is persistent or merely a characteristic of the market environment over that short time period.

So, should B|O|S be investing in smart beta strategies? Actually, we have been investing in smart beta strategies well before smart beta even became a term. Our equity portfolios are constructed to benefit from certain factors that are common in many of the new smart beta strategies. Specifically, our equity portfolios are tilted more towards small companies and value stocks. Unlike many smart beta strategies, these factors are grounded in academic research that has demonstrated value to investors over long periods of time.

Fund companies continue to introduce new smart beta strategies and this trend is likely to persist for some time. We are open to the possibility that some of these new strategies might enhance the structure of our clients’ portfolios. At the same time, we maintain a healthy skepticism towards many of these new strategies. We are well aware of the many new investing styles that have come and gone over the years, often to the detriment of those investors who embraced them. Consequently, we rigorously review any new strategy. This philosophy has worked well for us and our clients in the past and, in our view, is the smartest thing we can do going forward.

Filed under: Investing

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