Smart beta can be viewed as a third approach to investing (passive management through market capitalisation weighted indexing and active management being the other two) that combines the benefits of both active and passive management. Specifically, smart beta aims to achieve above market returns or below market risk, or sometimes both, by gaining targeted exposure to ‘factor premia’ while retaining the numerous benefits of conventional indexing such as simplicity, objectivity, transparency, and relatively low costs.
There are a number of smart beta indices that rebalance to an alternative set of weights and they fall into three categories with a focus on return, risk, or both return and risk:
1) Return focused
Equal weighting: where all companies in an index are weighted equally, irrespective of how large or small. Such indices have a small company bias relative to the corresponding market capitalisation weighted index;
Fundamental weighting: where companies in an index are weighted according to their economic size using, for example, an average of stock weights proportional to sales, dividends, cashflow and book value (the reason for averaging is that, taken individually, these simple measures all have flaws). Fundamental indices break the link between stock prices and weights and have a pronounced, albeit dynamic, value bias relative to the corresponding market capitalisation weighted index;
2) Risk focused
Risk weighting: where companies in an index are weighted according to their volatility with the aim of improving portfolio efficiency by making assumptions about future volatilities and/or correlations, generally based on historical observations. Risk weighting includes volatility weighting, equal risk contribution, and volatility minimisation approaches using an optimisation (eg risk efficient, maximum diversification, minimum variance, and targeted volatility); and
3) Return and risk focused
‘Factor premia’ weighting: where companies in an index are weighted according to their factor exposures – those sources of risk that compensate investors with returns. This can be implemented via long-only (‘risk premia’) and long-short (‘alternative risk premia’) strategies. ‘Factor premia’ factors are broad, persistent forces that exist both across asset classes (where macroeconomic factors determine levels) and within asset classes (where individual factors determine dispersion) and ultimately drive the risk and return profiles of equities, bonds, currencies, and other asset classes. Within equities, individual RIPE Factors™ include Value, Quality, Momentum, Small Size, and Low Volatility. Multifactor strategies, such as our proprietary and exclusive SMARTER Beta™ equity approach, employ a selected combination of various individual factors.
Empirical research confirms that these alternatively weighted indices, and hence the mutual funds tracking them, outperform relative to market capitalisation weighted indices with similar or reduced risk characteristics.
All of these smart beta approaches have three features in common. Firstly, they are not reliant on market capitalisation weights; secondly, they systematically rebalance back to a set of target weights where the periodic rebalancing captures the mean reversion of stock prices in a simple, robust fashion; and, thirdly, they are highly diversified in order to effectively exploit the negative cross-sectional correlations and noise inherent in financial markets.
Although there is a wealth of academic and empirical research demonstrating that Value, Quality, Momentum, Small Size, and Low Volatility each outperform over the medium to long-term, it is important to realise that on an individual basis these factors can move sideways or underperform for significant periods of time, sometimes a year or more.
Crucially though such factors are lowly correlated, or even negatively correlated, with each other because they tend to outperform at different stages of the market and economic cycles. For instance, Low Volatility and Quality tend to perform better during an economic slowdown whereas Value and Small Size typically outperform during an economic recovery. Momentum generally performs well except at the inflection points of the market cycle. This in turn provides the opportunity to meaningfully increase risk-adjusted returns at the portfolio level by blending the individual factors in a multifactor approach in such a way that there is persistent positive exposure to all the RIPE Factors™ in order to reap the full benefits of factor diversification.
At Aberdeen Asset Management, we advocate a multifactor approach that aims to provide simultaneous positive exposures to all targeted RIPE Factors™ – even when applied to a single factor like Value, for example – as we believe this to be superior to a single factor approach.
This is a key point as many competing single factor designs have factor exposures that, more often than not, are underexposed to non-targeted factors e.g. Value often has a negative exposure to Momentum, or even low beta, due to negative correlations. Given that all RIPE Factors™ are engineered to provide risk-adjusted excess returns over the medium to long-term, we believe this to be a design flaw in competing designs and one that we have consciously corrected in our multifactor approach.
Our SMARTER Beta™ equity indices include eight multifactor index families – Balanced Multifactor, High Income Multifactor, Value Multifactor, Quality Multifactor, Momentum Multifactor, Low Volatility Multifactor, Small Size Multifactor, and ESG Multifactor – across a range of global, regional, and local developed and emerging markets.
Interest in smart beta products, and multifactor strategies in particular, is mounting. Investors see the advantages of conventional indexing but are keen to obtain higher risk-adjusted returns and are sceptical of their ability to select active managers who can consistently outperform. Smart beta, and Aberdeen Asset Management’s proprietary and exclusive SMARTER Beta™ equity capability, is thus a third approach to investing that provides a pragmatic and cost-effective core solution to current investor needs.
David Wickham, Senior Investment Specialist
For further thoughts and insights, visit: http://www.smarter-beta.com/
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The value of investments and the income from them can go down as well as up and investors may get back less than the amount invested. A full list of risks applicable to this Fund can be found in the Prospectus and Key Investor Information Document (KIID), which is available from aberdeen-asset.co.uk.