Turning Smart Beta into Smart Alpha

Turning Smart Beta into Smart Alpha

September 25, 2017

Smart alpha combines smart beta and tactical asset allocation to address the shortcomings  of both approaches by giving investors the chance to beat the market during an upturn while still protecting investors during a downturn.

Over the past few years, smart beta strategies have been gaining market share.  The appeal is based on the idea that active money managers can’t beat market cap weighted indices and market cap indices are “dumb” in their security selection and weighting.  Smart beta is any strategy that weights securities in a way other than market capitalization by using backtesting to find alternative weighting schemes that have beaten market cap.   This approach has been gaining popularity for three reasons:

  1. Many market forecasters are predicting much lower returns for stocks over the next 10 years based on where valuations are currently.  If returns are lower, smart beta might provide an attractive alternative.
  2. Investors want the ability to beat indices like the S&P 500.  Historically active managers haven’t beaten their indices so if smart beta strategies can fulfill their promise going forward they provide an attractive alternative between active and passive investing.
  3. Marketing—The world doesn’t need another S&P 500 index fund.  If I am an ETF issuer then there is going to be more marketing sizzle in a smart beta product than there will be in another index fund.

There are a number of different smart beta strategies that have beaten market capitalization weighted indices on a historical basis.  Value stocks, small cap stocks, lower volatility stocks, momentum, stocks weighted by earnings quality, and dividend growers are some of the first smart beta strategies.  Some other strategies that can fit under the smart beta umbrella are hedge fund cloning and socially responsible stocks.

If smart beta does as well going forward as it did in backtesting then it could provide a viable alternative to traditional indexing.   However, there are a number of potential problems with smart beta investing:

  1. Backtests that show a smart beta strategy outperforms can be curve fit or data mined.  Curve fitting or data mining can make you think you have found an edge when one doesn’t actually exist.
  2. Just because a strategy had an edge in the past doesn’t mean the edge will persist into the future.
  3. A strategy may have done well in the past but now that everyone knows about it will it continue to do well?
  4. A strategy may have outperformed the market because it takes more risk, which could make this point in the market cycle a bad time to invest in it.  Small cap stocks for example have beaten the S&P 500 over the long term, however, I could argue this is because small cap stocks are riskier and investors are being compensated for taking more risk.  If we assume that we are closer to the end of the bull market than we are to the beginning then investing in small cap stocks now might not be the best idea.
  5. A strategy may provide an edge over the long term but over the shorter term it could substantially deviate from the market.  As practitioners we always need to consider the emotional aspects of an investment strategy.  For example, there is a lot of good research showing that value stocks outperform growth stocks over time.  However, there are also long periods of time when value underperforms, making it hard for investors to stick with such an approach.
  6. If we are close to a bear market or a substantial correction then smart beta strategies may do better than the S&P 500 but they will still lose a lot of money.

Combining Tactical Asset Allocation with Smart Beta to Create Smart Alpha

Like smart beta, tactical strategies have also been gaining in popularity over the past few years.  Tactical strategies seek to identify potential market turning points to protect investors from market downside.  Typically they attempt to beat the market over a full cycle by limiting losses in a bear market while underperforming during an up market.  This approach is appealing to investors when a bear market isn’t far from recent memory.  Unfortunately, as we get further into a bull market, it becomes psychologically more difficult to consistently underperform.  Investors still like the idea of having the downside protection of a tactical strategy but they are not sure that they will need it when all they see is the market going up.  Investors tend to believe that the most recent past will equal the future.

For tactical strategies to stay relevant during a bull market they need to be able to beat or at least come close to matching index returns.  A way to do this is to combine smart beta with tactical asset allocation.  For example you can take a smart beta factor like dividend growth to create a basket of stocks that have consistently grown dividends.  Unlike smart beta which would just buy and hold those stocks, you can put them into tactical models so that you are invested in them during an up market but go to cash, or some other protective asset, during a down market.   This approach gives you the benefit of a smart beta strategy during an up market and the benefit of a tactical strategy during a down market.  It also gives an investor the chance of outperforming the market during a bull market while still providing downside protection.

Combining smart beta with tactical asset allocation creates a smart alpha strategy that gives investors the ability to beat the market during an upturn while still being able to protect during a downturn.

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