So-called ‘smart beta’ strategies (a term that we use to describe products that offer passive-like exposure to factors) are relatively new but are already becoming a de-facto industry standard. Global smart beta adoption rates climbed to 46% in 2017 from 26% in 2015, according to data from FTSE Russell, with multi-factor and low volatility the top two strategies. One report forecasts smart beta strategies could make up about a third, or US$300 billion, of the US$1.1 trillion in net inflows into passive/indexed strategies between 2016 and 2020.¹

The rapid adoption of smart beta is in part based on indications long-term performance will beat broader benchmarks. But there are reasons to question this view. The typical factor indexes upon which factor ETFs are based have a short real-life history, which means their back-tested performances are not necessarily replicable. There is also growing evidence that the outperformance of smart beta strategies is simply driven by the choice of investment factors in the portfolio, rather than any unique qualities. This could potentially disappoint investors making choices based on historical performance or an alleged investment ‘edge’ if the strategy fails to meet expectations.

The smart beta approach is not so much a passive option as it is a ‘quasi active’ strategy that can be used as an alternative to passive weighted indexing or active investing. While it certainly has the potential to outperform, it is constrained by a lack of diversification, the overlapping of multiple stocks across investment styles, and the presence of unrewarding macroeconomic risks -- all of which can hurt performance in times of market stress.

For instance: a low-volatility smart beta strategy might track the MSCI Minimum Volatility index, which is one of the most popular low-volatility indexes -- but this limits the portfolio to fewer than 300 stocks. If investors discover this lack of diversification leaves them exposed to a certain premium-free macro risk, there’s no way to change tack. They may invest in a combination of strategies based on various factors, or a multi-factor strategy to correct the excessive ‘tilt’ towards certain risks, but this doesn’t always resolve the issue of being unable to act if market conditions shift. It also doesn’t necessarily achieve diversification, since many stocks combine several factors (such as quality and value) and will thus play a role in multiple strategies.

A carefully and actively integrated portfolio has a better chance of achieving outperformance and mitigating non-rewarding risk than generic combinations of individual smart beta strategies. Portfolio managers operating at the individual stock level have the freedom to choose from a far broader universe of factors and companies, and to combine these in novel ways. They can buy high-dividend stocks with low momentum and vice versa, making sure that the degree of overlap remains limited. They can also pick a mix of low- and high-beta stocks, as well as stocks with varying degrees of sensitivity to non-rewarding risks such as oil price swings or changes in interest rates.

The manager may even apply the approach across asset classes, to add a further layer of diversification. The end result is a portfolio dispersed across various dimensions of risk to foster a degree of independence from both other strategies and market events, and one that captures risk premiums in a more stable way than a basket of smart beta indexes. While the ‘smart beta’ universe may be expanding, it is not as broad as it may initially appear –- and increasingly subject to limitations.