Outsmarting beta to beat the averages

13th March 2012

As the passive and active camps became more intractable, attempts to find compromise positions came to the fore. There was the 80/20 hub and spoke structure where a number of actively selected stocks (the 20%) surrounded the largely passive hub.

And many advisers pushed an umbrella concept, especially to private investors. Here most of the money goes into Exchange Traded Fund indexed stocks with a small balance invested in actively managed funds. The claimed advantages of these two strategies are costs and lower volatility.

Damp down the risk to get alpha

The idea of both is to dampen down risk by getting close to an indicator called beta while allowing for the potential of some alpha – a measure of success once risk is considered.

Beta calculates how a stock, a portfolio or a fund measure up to a control such as an index.  A beta higher than one means more volatile than the index; under one is for investments that swing less violently than the control. The hub or the ETFs provide the beta of one; other funds or stocks can raise or lower the beta but, as they are a minority of the whole, by smallish amounts.

It is relatively easy, if only for a time, to beat an index by opting for high risk stocks – think the dotcom boom. But if an investor can beat the market without going high beta crazy, they have achieved alpha.

Smart beta the latest fashion

According to The Financial Times, Smart beta is the latest fashion for pension and other investment managers who do not want to scare investors but want to offer more than a standard index tracking technique.

Smart beta is effectively investing in a custom-built index. A ready made portfolio of high volatility stocks in an ETF may make sense for some; others want low volatility; a third group might want high dividends with good cover.

One example of smart beta would be a portfolio based on a low price/earnings ratio – a manager might consider these stocks have further to rise and not far to fall – but the permutations are endless. You are looking for "systemic anomalies" which can give gains beyond the value of the underlying companies themselves. The essential is that the investment professional sells the concept while stock selection is left to an automatic filter that chooses the individual shares in the ETF.

According to figures from Northern Trust, a wealth management group, 51 per cent of investors globally are interested in exploring these strategies to meet their objectives.

So smart beta is a middle way strategy – passive because fund managers do not choose the stocks but active in so far as the manager has to select a strategy. 

Defenders of smart beta say this is no different from a decision to invest 70 per cent of a client fund in the US S&P 500 and the balance in the FTSE All-Share. Someone has to think about that – rejecting, for example, a multitude of other options such as putting equal amounts in four different indexes or the whole lot in one.

Index funds are liked by investors for their transparency, low cost and ease of understanding. The key question is whether smart beta lives up to those three criteria.

Costs should be lower because using a filter rather than an active choice strategy is cheaper; and investors should see what they are getting and why.

 The danger is that the portfolio will be expensive to construct, hard to comprehend, and opaque.  Even worse, it will deliver negative alpha. And some investment managers will be tempted to create concepts that are only sold to one investor.

Even more dangerous is the temptation to create a smart beta portfolio based on a concept that has worked in the past but which will not work in the future as it becomes too well known, allowing other managers to isolate it and bet against it.

Ideas no longer with us

There are plenty of investment ideas that have passed away – from the Nifty Fifty to 130/30 funds and the January effect.  They became too well known – successful investment is all about harnessing the unknown to your advantage.

Only time will tell whether smart beta is an enduring fashion or a passing fad.


More from Mindful Money:

Volatile markets and how they can make you money

Is the 'risk on, risk off' investment style on or off?

ETFs: 'could pose a significant danger to investors at times of high market volatility'

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2 thoughts on “Outsmarting beta to beat the averages”

  1. Anonymous says:

    Thanks Simon – does this mean that the portfolio effect of QE is working?

    1. Simon Ward says:

      IMO yes – although the effect is from interest rate cuts and liquidity injections to the banking system rather than QE proper (i.e. bond purchases from non-banks).

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