Smart beta

Abstract: Factor returns, net of changes in valuation levels, are much lower than recent performance suggests. Value-add can be structural, and thus reliably repeatable, or situational—a product of rising valuations—likely neither sustainable nor repeatable. Many investors are performance chasers who in pushing prices higher create valuation levels that inflate past performance, reduce potential future performance, and amplify the risk of mean reversion to historical valuation norms. We foresee the reasonable probability of a smart beta crash as a consequence of the soaring popularity of factor-tilt strategies.

Abstract: Research on socially responsible investment in equity markets initially focused on sin stocks. Since then, the availability of data has been extended substantially and now covers environmental, social, and governance (ESG) criteria. Using ESG scores of firms belonging to the MSCI World universe, the authors measure the impact of score-based exclusion on both otherwise passive investment and smart beta strategies. They find that exclusion leads to improved scores of initially standard portfolios without deterioration of the risk-adjusted performance. Smart beta strategies exhibit a similar pattern, often in a more pronounced way. Moreover, the results demonstrate that exclusion also implies regional and sectoral tilts as well as (possibly undesirable) risk exposures of the portfolios. TOPICS:Portfolio theory, portfolio construction, ESG investing Key Findings • The authors show that environmental, social, and governance (ESG) screening can substantially improve ESG scores for both otherwise passive and smart beta portfolios without reducing risk-adjusted returns. • Starting from initially passive multicountry portfolios, ESG screening may lead to substantial regional tilts, such as overweighting Europe and underweighting the US and emerging countries or sectoral bets, for instance in favor of information technology and against financial and energy stocks. • Although the broad conclusion of improved ESG profile without affecting risk-adjusted performance also holds for smart beta portfolios, aggressive exclusion of ESG low-scoring firms may lead to some reduction in exposure to targeted factors.

Abstract: Smart beta products are a disruptive financial innovation with the potential to significantly affect the business of traditional active management. They provide an important component of active management via simple, transparent, rules-based portfolios delivered at lower fees. They clarify that what investors need from their active managers is pure alpha—returns beyond those from static exposures to smart beta factors. To effectively position themselves for this evolution in active management, asset managers need to understand the mix of smart beta and pure alpha in their products, as well as their comparative advantages relative to competitors in delivering these important components.

Abstract: There is a popular new investment strategy in portfolio management called smart beta. With a catchy title and a promise of improved portfolio performance, the strategy has already attracted hundreds of billions of dollars and is growing by leaps and bounds. Unfortunately, according to the author smart beta portfolios do not consistently outperform and when they do produce appealing results, they flunk the risk test.