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Smart Beta

We live in an ironic world. Common sense is definitely not all that common, social networks are decidedly anti-social, and I can’t think of anything less “smart” than my so-called Smart TV. Below we size up “smart beta”.

We have touched on the general concept of beta elsewhere, but for the late-comers at the back here is a brief revision. Beta is a measure of the amount that a portfolio (or share, or fund) rises or falls relative to the wider market, the usual proxy being a capitalisation-weighted index such as the S&P 500 in the US. “Beta investing” is thus the passive investment strategy of tracking an index and earning the return of the market, as opposed to trying to beat it.

Making beta investing “smart” simply means choosing to track an index that’s actually worth tracking. Consider that capitalisation-weighted indices will by nature assign a lower weight to undervalued stocks and a higher weight to overvalued stocks. This runs foul of sound investment sense. Instead of weighting stocks by their size, what about weighting stocks by their dividend yield, or their price-to-earnings ratio? Instead of favouring the largest, what about favouring the most profitable, or the least volatile? Smart beta is a broad-brush term to refer to systematically and passively tracking an index that is not capitalisation weighted. If you think of ‘alternative index’ investment, you have got the nub of it.

You will notice that this definition is opaque. If you pick your twenty favourite stocks and equal weight them – well, that arguably could be smart beta too. Needless to say, not all smart beta strategies are all that smart. Indeed the term is presumptive to the point of smugness. Strategies based on back-testing over a relatively short time frame can produce results that turn out to be spurious. To test fully whether a quantitative strategy works, one must look back across various economic cycles and for very long periods of time (at least fifty years), and always ensure there is an economic rationale that can explain why the strategy should work. If your back-testing reveals companies that start with a vowel are outperformers, something is not right.

Smart beta has opened a world of specialist predilections, that of factor investment. If you decide that you want to bias your portfolio to momentum, or to value, or to domestic or overseas earnings, or high growth or deep value, there will be a smart beta fund to fit every possible penchant. But if all a mine needs is a piece of ground and a man with a pick, a smart beta strategy needs only a spreadsheet and a set of rules. To access smart beta you do not have to scour the lists of exchange traded funds to find whatever is tickling your fancies, all you need is your own screen and some strict rules.

The advantages of truly “smart” smart beta are manifest. Fees: it will always be far cheaper to invest by computer rather than human thought. It is rules based: quantitative, objective, and bias-free. This is key, since the human brain is wired for survival on the savannah, not patient investment self-control. Diligently following a rules-based investment strategy adds discipline and can help avoid some of the most common investor mistakes that have a tendency to result in buying high and selling low.

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