They can be seen as an alternative to both market capitalisation-based passive strategies and traditional actively-managed strategies depending on an investor’s perspective and they tend to sit between the two in terms of cost. This segment of the market has become increasingly popular over recent years, with many well-established asset managers coming to market with new and interesting product launches.
To understand what industry participants mean when they refer to smart beta strategies, it is perhaps important to take a step back and look at the relationship between ‘beta’ and ‘alpha’.
Beta is a term that describes the degree of market risk a fund manager is taking but it is also a term used to describe the performance of a traditional index in a selected region over a period of time. Alpha is the excess return a portfolio provides over and above the performance of ‘the market’.
For example, in the US the S&P 500 Index is generally regarded as ‘the market’ for US stocks, representing around 80% of the publicly-traded stocks in the US by market capitalisation. It is seen as a good representation for the overall US stock market and as such the returns of US equity managers are generally compared to the returns of this index. If a fund manager delivers a return of 15% on his/her portfolio in a given year versus a return of 12% for the S&P 500 Index over the same time period, 12% of the fund manager’s performance is attributable to beta or market exposure, with the remaining 3% (the outperformance) labelled alpha (see chart 1).
When an active manager delivers performance over and above the return of the benchmark, it is intuitive to think of that excess return as being a function of the manager’s skill, insight, and hard work, and a direct result of deliberately placed bets.
However, fund managers often have a consistent style or an approach to managing their portfolios which results in the targeting of stocks with certain characteristics. This is often embedded into their overall philosophy, and filters through to the process they apply, allowing them to scan the universe of stocks available to them and select the combination that best meets their criteria.
These differing styles and approaches to active management can make it difficult to work out whether a manager’s performance versus their benchmark over a given period is truly a reflection of their skill or whether their inherent biases towards certain types of stocks will have been the main driver of returns.
