Can smart beta really perform better?

December 2014

Right now there’s a lot of talk around smart beta. The term can be a little hard to define and sometimes goes by other names, such as advanced beta, alternative beta or strategy indices. However, in essence, it’s a form of passive, whole market investing, but with a twist.

The idea is to increase return or take on less risk by weighting or selecting the stocks differently to the market capitalisation approach of ordinary beta. This could involve changing the fundamental variables or risk measures or even introducing a theme. Smart beta is something of a grey area, but the attraction lies in getting a little extra performance at very little extra cost. That’s why pension funds like it, but does it live up to the hype?

There s no reason stocks can’t be weighted or selected in a different way. Market capitalization is the conventional but not the only way of doing it. However, at its core, is the idea of capturing a risk premium. Unfortunately, not everything that gets called a risk premium truly is a risk premium. Rather than a risk premium, what many of these funds are trying to capture is a bit of extra performance on top of the index - what people in the industry call

This means that, in practice, you have to hold these funds to account in the same way you would a manager who is paid to do the same thing. And the fund needs to be based on robust research rather than a simplistic formula. So if you’re considering such a fund you have to study it as you would study a fund manager. It may sound attractive to pay a few base points for an index and maybe 30 base points for smart beta, when the alternative is 90-100 for an active manager.

Many people might think, “Yes, it’s slightly more expensive, but I get this outperformance”. But what they’re actually paying for is a rudimentary, version of what a manager does in considerably more depth. After all, if a manager can get you four or five per cent extra, the additional cost barely matters. We think you should treat these products as a kind of specialist investment service and analyse them in them carefully. They may be called smart beta but some of them are more like dumb alpha.