How smart beta strategies became all the rage

Given the uncertainty around inflation, interest rates and energy prices, as well as geopolitical concerns related to the war in Ukraine, the one thing investors broadly agree on is that equity markets are bound to remain volatile.

There is, however, a broad consensus on the most effective way to invest. In a landmark study by EquitiesFirst in conjunction with Institutional Investor, smart beta strategies came out ahead when investment decision-makers at global financial institutions were asked to rank the two investment strategies they believed would deliver high returns over the next two years. Smart beta investing was especially favored by investors focused on the world’s most liquid and developed equity markets, while those involved in developing markets showed a preference for fundamental, bottom-up active strategies.

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Smart beta investing is essentially an alternative way to take passive exposure in markets by applying some of the factors rules used in active management – such as value, momentum, low-volatility and quality – to fine-tune broad index strategies. Investors generally see smart beta investing as a way to complement or tactically enhance overall performance within a diversified portfolio, at a lower cost compared to actively managed strategies.

The factor weightings applied to smart beta funds can be revised as market conditions evolve, meaning there is scope for more frequent rebalancing than with traditional index funds.[1]

As such, smart beta ETFs are sometimes described as “quasi-active.” Though this tends to give them slightly higher expense ratios than market cap-based passive benchmark index products, their fees are still considerably lower than those of actively managed funds.

The balance has tipped

Last year marked a milestone in the gradual shift away from actively managed equity funds, with assets under management in passive funds surpassing active funds for the first time.[2] Smart beta ETFs constitute a steadily expanding share of the passive investing universe, accounting for just over 16% of all ETF assets under management (AUM) in the US at the end of 2022.[3] At current growth rates, they are projected to reach US$1 trillion in AUM by the end of 2023.

In addition to being well suited to current market conditions, smart beta strategies are clearly also in vogue because of their recent strong performance, having delivered returns as high as 15%[4] last year even as major markets fell by around 20%. Among these, multi-factor ETFs – as opposed to those managed with a single factor weighting – were considered the “hot ticket.”

Not best for all markets

Still, smart beta ETFs may not be the best way to access all types of markets. According to the survey data and interviews from the EquitiesFirst x Institutional Investor study, they are best suited to the developed markets of North America, Europe, and Asia-Pacific – as opposed to developing and emerging ones – due largely to their efficiency and robust trading volumes.

Investors focused on North America, for example, noted that it was rare for active stock picking strategies to outperform in local markets. Portfolio managers focused on such developed markets over the past decade have tended to invest the bulk of their capital passively in large-cap equities to keep up with the relevant benchmarks, while taking smaller positions in small caps and emerging markets to seek alpha at the periphery.

By contrast, in emerging markets, which are generally characterized by inefficiencies, skilled managers can reliably outperform the broader market.

In the higher risk/return markets of developing Europe and Asia-Pacific, where information for investment decision making is at times uneven and trading volume is thin, the study found that concentrated high-conviction strategies are more likely to be viewed as highly effective.

More broadly, the study reveals that institutional investors value diversification and index-based strategies as the foundations of any equities portfolio. Individual investors can adopt a similar approach through smart beta funds.

With 1,275 different smart beta ETFs listed globally on 48 exchanges in 38 countries,[5] there is certainly no shortage of choice. Investors should pay heed to the key differences among them. They must assess the merits and current relevance of the indices, biases and specific factors used by each strategy. They should also consider which firm constitutes the underlying index and which sponsors the ETF.

Having determined which smart beta ETFs are right for them, investors can turn to securities-backed financing to access liquidity to acquire them. Using their equity or crypto as collateral, they can secure a flexible, cost-effective and stable source of capital, with which they can maneuver deftly into new positions and strategies without sacrificing upside from their underlying holdings.

With volatility likely to remain a feature of the global equity markets for the foreseeable future, it is hard for equity investors to know where to turn. The survey of institutional investors suggests that smart beta strategies are worth a closer look.







Past performance does not guarantee future returns, and individual returns are not guaranteed or warranted.

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