Toward a Better Beta

mouse and maze_edited-1The term smart beta is often heard in the industry, but there isn’t always consensus about what it is and how it should be used. In its most general definition, smart beta is any passive approach that differs in some way from the traditional broad market-capitalization weighted index approaches. Smart beta can be used within a portfolio to provide specific exposures to market segments or factors, which can be helpful in achieving a particular goal.

One appealing use of smart beta is to control for unwanted exposures in a portfolio. For example, within developed equity asset classes, active managers tend to prefer stocks with higher levels of volatility. There are several reasons why this may be the case. Active managers who are incented to outpace the broad market will gravitate to stocks with higher risk in anticipation of a higher payoff. The asymmetric reward system for active management also encourages managers to choose riskier stocks in their aim to be top performers (the benefits of being a top-performing fund are much greater than those of being an average fund).

Additionally, stocks with low volatility behave differently than the rest of the market, which can lead to higher tracking-error levels. Tracking error is a measure of how closely a portfolio follows the index to which it is benchmarked. This elevated tracking error can make low-volatility stocks unappealing to active managers who are being held to a tracking-error target.

At the same time, the volatility factor has had a negative historical performance. Volatility gives a measure of an asset’s relative volatility over time according to its historical behaviour. The Axioma risk model shows the cumulative return to the global equity volatility factor has been negative 70% over the last 15 years. A smart beta approach could be used to control for this volatility exposure easily and at a relatively low cost.

There are several approaches that could be taken to neutralize this unwanted volatility exposure.  One compelling idea is the introduction of a passive defensive equity product. Defensive indices blend a low-volatility approach with a high-quality approach. Through the use of defensive indices, investors get exposure not only to low volatility but also to three quality factors: low earnings variability, low leverage and high return on assets.

For every pension investor, the unique aspects and inherent biases of their existing portfolios will inform what type of smart beta approach is most appropriate. If these biases aren’t intentional, they should take steps to control for any unwanted exposures. A smart beta approach is one way to do this.

Rachel Carroll is senior consultant, Russell Investments, U.S.