Defining “smart beta” indexes and how these new tools can be useful for investors - SmartBrief

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Defining “smart beta” indexes and how these new tools can be useful for investors

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Finance

Rolf Agather is Managing Director of Global Index Research and Innovation for Russell Investments.

Rolf Agather is Managing Director of Global Index Research and Innovation for Russell Investments. In this email interview with SmartBrief, Mr. Agather provides context for the new crop of “smart beta” indexes and how they may be useful to investors.

Question: What is “smart beta” and what are some of the advantages to these indexes? 

Answer: “Smart beta” is an often used but, in my opinion, not widely understood term.  Smart beta refers to an emerging set of indexes that move beyond broad market exposure. These indexes use new methodologies to deliver more specific, specialized or “smart” market exposure to the end user. In the context of index development, smart beta refers to a transparent, rules-based methodology designed to provide specific exposure to market segments or factors. For years market indexes were provided to offer very broad, market capitalization-weighted exposure to asset classes.  Smart beta is generally differentiated from more traditional indexes by breaking the link to market price (and resulting company size). This can mean focusing on specific geographic exposure, or exposure to certain market factors such as volatility, momentum or other alternative weighting methodologies. Much like the term “hedge fund” has been used historically for a wide cross section of investment vehicles, “smart beta” is a convenient term referring to a broad and multi-faceted set of new index tools for portfolio construction and analysis.

Q: What are some of the most common smart beta indexes?

A: I like to say that Russell created the first “smart beta” indexes back in the early-80’s with the introduction of the Russell 2000® small cap index, and later in 1987 with the Russell Value and Growth Indexes. These were the first institutional-quality indexes that looked beyond broad market exposure to divide the market into large and small, as well as growth and value-oriented stocks. Today, the style box is still widely used as a framework for equity investing.

Our understanding of indexes is evolving in the smart beta category, and can be difficult to neatly define. To help simplify, we generally categorize smart beta indexes into three broad groups:

  1. STYLE: Dynamic and defensive indexes now offer the next generation of style by taking a more sophisticated approach to dividing the broad market according to momentum and quality factors. Extensive research into the characteristics of defensive and dynamic stocks revealed that they are distinguished by two factors: quality and volatility. Stocks classified as defensive tend to have higher quality and lower volatility measures. Dynamic stocks have relatively weaker accounting-based measures (quality) and higher volatility, and are pro-cyclical in their performance.
  2. WEIGHTING: Equal Weighted indexes are one of the first, and thus best understood approaches to smart beta. Alternatively weighted indexes can use various criteria to re-weight securities. These criteria might include equal weighting, to even out the impact of price and size on weightings, or fundamental weighting, which ranks constituents based on non-price measures of company size rather than stock price.
  3. FACTOR/TARGETED: Factor approaches provide concentrated exposure to stocks exhibiting certain factors. These types of factor approaches include momentum, low volatility or quality. Low volatility, for example, can offer minimal exposure to other systemic “risk style” factors such as size, exchange rate sensitivity, and value.

Q: Does the fact that there are “smart beta” indexes now imply that existing indexes are less smart?

A: Beta is beta. It is the measure of the market. By definition, if an index is adequately measuring the market it is not dumb. The  ‘smart’ in smart beta really refers to the additional layers of thought and sophistication inherent in these new indexes. Indexes that can, in turn, help investors have smart tools for (and greater flexibility in) portfolio construction and management. The new alternative beta, or smart beta, indexes we are describing are not designed to replace traditional market capitalization-based indexes, which are still the most efficient way to gain broad-based exposure to general asset classes and global markets. Recent index innovations are a complement to the existing indexes and active strategies available to investors, allowing for finer cuts on market exposure, factor exposure and portfolio weighting approaches. While these newer indexes extend the traditional definition of market beta, they continue to offer the systematic exposures investors can use to create their desired portfolio construction outcomes.

Q: How can a “smart beta” portfolio complement other investment strategies or integrate into current portfolio allocations?

A: Smart beta indexes are just another tool for portfolio construction, which will always require a level of human oversight and a broader context not easily attained for individual investors. It is important to note that index-based investment strategies do not seek to replace active portfolio management, but to complement active and passive exposures. Smart beta indexes can be used in a myriad of ways. The use case will vary by investor. For example, an investor might use a smart beta index to reduce portfolio risk by allocating a certain percentage of the portfolio to low volatility and quality-oriented stocks. Smart beta indexes might also be used for diversification, through a geographic revenue-oriented index or a non market capitalization-weighted index. Or a smart beta index might be used to increase portfolio yield potential by providing exposure to high dividend-oriented stocks. Our clients have increasingly utilized index-based exposures within a broader portfolio context to help address their unique investment challenges.

Q: What are some of the drawbacks to tracking these indexes advisors should consider?

A: Like any investment tool, strategy or product, with any index-based approach financial advisors and investors need to understand how underlying indexes work to determine their roles in portfolio construction. Most smart beta index strategies are newer to the market, and can be less transparent and harder to understand than their cap-weighted predecessors. Lack of extensive live track record, and the fear that optimizers and more complicated algorithms are a “black box,” never to be understood or trusted, can be deterrents to investors that haven’t spent adequate time understanding the intention and methodology of these indexes. For these investors, traditional market capitalization-weighted indexes may still be the best approach in gaining broad market exposure across major asset classes and global markets. For other investors, a somewhat more sophisticated use of new smart beta index approaches may be in order. In either case, it is extremely important to be intentional in how you are looking to use indexes as part of an actively managed global multi-asset portfolio strategy. Advisors need to understand how indexes are constructed, what objectives they are designed to capture and the types of stocks they are designed to select and screen for in order to best incorporate them into a client’s investment portfolio.

Q: Where can our readers go for more information on smart beta indexes?

A: At Russell we believe not all indexes are created equally. It is fundamentally important to understand index methodology, and the differences between the exposures provided by competitive indexes. This idea is increasingly important when it comes to the complexities of smart beta index construction. More information about Russell indexes can be found at www.methdologymatters.com  and www.Russell.com/Indexes, where we provide information, resources and research on our index strategies.

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