Smart beta is clearly growing in popularity with investors. According to data from ETFGI, assets invested in smart beta equity funds listed reached a record high of $429bn in June 2016, an increase of 7.1 per cent over the year to date. 
Interest in smart beta products has grown, in part, due to investors’ greater demand for transparency and lower costs, as well as their desire to move away from the concentration bias of market capitalisation-weighted indexes.
Market capitalisation-weighted indexes weight stocks according to their total market value (stock price x total outstanding shares) and are often criticised for being overexposed to the largest companies in an index or concentrated in a few sectors.
Furthermore, market capitalisation-weighted indexes end up overweighting the overvalued (and arguably expensive) stocks and underweighting the undervalued (and arguably cheap) stocks.
Smart beta products attempt to address the inefficiencies created by market capitalisation-weighted indexes by breaking the inherent link between a company’s equity market capitalisation and its weight in an index.
In its most basic definition, a smart beta strategy is one which systematically selects, weights and rebalances a portfolio on the basis of anything other than the traditional market capitalisation. Therefore, smart beta is often described as sitting somewhere in between passive and active management. Strategies are passive in that they track an index but active in their construction, in that the index they track has been customised.
The most popular smart beta equity strategies tend to fall within three broader categories: factor, fundamental and low-volatility investing.
The aim of factor investing is to tilt portfolios towards factors that are typically long term drivers of returns such as value, size or momentum (at least those proven to in academic research).
Fundamental weighting uses accounting-based metrics such as sales, profitability ratios etc to weight stocks in an index.
Low-volatility strategies aim to improve the return per unit of risk of a portfolio, in general, by investing in stocks as a proportion of their volatility (inverse proportions) or running minimum variance optimisation across an index to suggest portfolio weights.
Smart beta products are competitively priced and allow investors to access different themes, which may be present in actively managed funds, but at a lower cost. Smart beta products are transparent and the consistent investment approach helps investors to better identify the risks and drivers of returns within portfolios.
The wide variety of smart beta products provides greater investment choice and the flexibility to better tailor portfolios to an investment view. They can add an additional layer of diversification as portfolios can be constructed to reflect different underlying factors with lower correlations, dependent on the stage of the economic cycle. This allows investors more freedom to express tactical investment views.
For example, value stocks tend to perform strongest at the early stages of an economic recovery, whilst low-volatility tends to perform strongest in the latter stages of an economic cycle.
Many argue that smart beta products also benefit from eliminating human emotion when investing. For instance, smart beta's mechanically-driven and disciplined process removes the behavioural bias of hesitating when purchasing unloved stocks or selling stocks after strong rallies.
With that said, smart beta does not come without risks. Moving away from a market capitalisation-weighted index will decrease your exposure to specific biases, but in the process create new ones.
For instance, moving to a FTSE 100 equally weighted index will lower your sector allocation to energy and consumer stables, but increase your exposure to consumer discretionary and industrials, in the process significantly altering the drivers of index performance.
Similarly, whilst some smart beta factors have been proven to outperform over long time horizons, in the short term those same factors can significantly underperform a market capitalisation index, creating a large tracking error for benchmark aware investors.
One of the pioneers of smart beta, Rob Arnott, chairman and chief executive of Research Affiliates, has warned of a potential crash caused by smart beta products. In a recent report, he highlights that the success of a number of popular smart beta strategies is a result of the underlying stocks becoming more expensive, rather than from the strategy producing structural alpha.
The report indicates that the recent success of smart beta strategies has led to a surge of investor inflows, pushing the valuations in smart beta strategies to levels far above their historical averages, giving the illusion of superiority.
The report notes that much of the success of smart beta products is a result of rising valuations, and net of valuation changes the success of smart beta strategies appears far less impressive.
Furthermore, the report warns that rising valuations reduce potential future returns and leave investors vulnerable to asymmetric losses, should stocks mean revert to historical averages. The report concludes “if rising valuation levels account for most of a factor’s historical excess return, that excess return may not be sustainable in the future, indeed our evidence suggests that mean reversion could wreak havoc in the world of smart beta”
Overall, we believe, providing investors have done their homework, the inclusion of smart beta in a portfolio can significantly improve its risk-adjusted return profile.
Relative to active management, smart beta can lower costs and improve a portfolio’s transparency. Furthermore, the wide variety of smart beta strategies as well as the ability to lower correlation within a portfolio provides diversification benefits to a portfolio.
However, as is the case with any investment, investors must understand the risks and bias of an index investment. Investors must be comfortable and understand in what environment a smart beta factor is expected to perform well and investigate the valuations of the underlying stocks within that smart beta strategy.
Only then can one make a reasonable assumption about future returns and be comfortable with the sector and stock bias of a smart beta strategy.
Dan Smith is an investment analyst at Thomas Miller Investment. The views expressed above are his own and should not be taken as investment advice.