Why A New Smart Beta?

What is Smart Beta? And why do we need it?

Smart Beta is a method to rebuild a portfolio with a weighting scheme different from the market capitalized weightage method. The weighting scheme can be based on fundamental factors different from size e.g. revenue, economic value etc. Most popular benchmarks today are built using the market capitalized method. The Asset Owners, Investors, and Asset Managers need Smart Beta because the industry needs a method to beat the S&P 500 and other market cap-weighted models. Why do we want to beat the S&P 500? Because S&P 500 is concentrated, hence risky, and buying more of the winner as it goes up is not the most efficient way to build a market benchmark or a portfolio. Everyone needs alpha i.e returns above the benchmark [above the S&P 500]. Alpha is a sign of intelligence and hence the need for a Smart Beta industry.

"Smart Beta is a method to rebuild a portfolio with a weighting scheme different from the market capitalized weightage method."

How is Smart Beta Constructed?

Smart Beta should be an Apples to Apples approach [but at times it assumes concentration], which means if the benchmark has 500 stocks, the Smart Beta portfolio has 500 stocks. Smart Beta is also designed as a low-frequency, slow, passive portfolio that has a similar risk to the benchmark. Smart Beta has been traditionally seen as an innovation on equity markets.

"Smart Beta should be an Apples to Apples approach [but at time it assumes concentration], which means if the benchmark has 500 stocks, the Smart Beta portfolio has 500 stocks."

Why did early versions of the Smart Beta fail?

As a group Smart Beta manages 6 trillion USD today. And as a group it has failed to deliver alpha and proved not to be “Smart” and is considered broken by design. There are many reasons. The industry has conventionally focussed on fundamental factors instead of quantitative factors. Fundamental factors are known to persist and fail. Industry can not anticipate for the longer term whether Value as a style is going to beat Growth as a style or vice versa. Smart Beta has not been able to traverse outside equity markets into commodities and alternative asset classes because it continued to have a narrow focus which emerged out of fundamental data. This is why the idea has failed to reach the needed consistency and robustness that is required for dealing with global capital markets. Markets are complex and linear, constrained, non-scientific approaches fail can’t evolve and adapt.

"As a group Smart Beta manages 6 trillion USD today. And as a group it has failed to deliver alpha and proved not to be “Smart” and is considered broken by design."

Figure 1: Smart Beta underperformance vs. Factor Returns

Why now?

With early Smart Beta failures behind us, the industry has acquired more knowledge regarding the complexity of modeling fundamental factors. A secular bull market has seen factors falling in and out of favor. Growth emerged as a top factor in the secular bull market, till the momentum crash happened and raised a big question of the factor's long-term consistency. Above this, the small investor revolution has seen a new generation of traders make and lose money and realize the value of the passive low-fee industry. New technologies have seen the emergence of new do-it-yourself ideas like Direct Indexing. Passive’s eventual takeover of the active industry also assists the Smart Beta innovation. Investor education makes it easier for the adoption of new Smart Beta approaches that can stand out of the crowd and deliver alpha. Markets will continue to innovate and zero-fee ETFs that charge only on Alpha create a large opportunity for the Smart Beta industry.

"Factors are always falling in and out of favor."

Figure 2: Weighted average equity ETF fee?(%)

Source: Deloitte Performance Magazine

The New Smart Beta

Our Exceptional & Rich [E&R] Method is a Smart Beta method that is agnostic to the region, to the asset, to the mandate, and to the fundamental factor. Persistence and reversion underlies all natural variables. Every variable is designed to fail as it comes in prominence because, the more a variable is know the less likely it is to work. Nature is complex and hence information can't be understood in a linear way. This is why understanding markets or complexity requires a redefinition of information away from its content and into its commonality. And the only laws that can create an objective generality are the laws of Science.

"Persistence and reversion underly all natural variables."

Our E&R method is an open framework that builds Indices. The differentiation of the E&R method from the rest of its peers is its nonlinear approach to markets. Our method assumes markets to be dynamic and uses statistical factors instead of fundamental factors. You can test and validate our method on our open Sandbox on GitHub.

"Markets are dynamic systems."

Bibliography

1] All about, alpha, beta and smart beta, Fidelity Learning Center

2] Smart Beta - What you need to know, FINRA, August 2022

3] Arnott. R, What Smart Beta means to us, Research Affiliates, August 2014

4] Bruno. Florent, Will smart beta ETFs revolutionize?the asset management industry? Deloitte, September 2021

5] Rabener. N, Smart Beta: Broken by Design?, CFA Institute, February 2019

6] Goodhart's law

AlphaBlock Team