Smart Beta - Dynamic Factor Allocation

Assets in Smart Beta funds are at an all-time high, showing compound average growth of more than 30 percent over the past five years, as investors seek new ways of managing risk and enhancing their portfolios’ performance. Interest in the investment approach was initially triggered by the difficulty investors were having in finding performance through traditional management based on the expected return from equities, mainly because of market shocks over the last decade. Smart Beta and Factor Investing solutions were able to bridge this divide, providing enhanced long-term potential performance by focusing on managing risk. It’s now a firmly established investment strategy, poised for further growth as it meets investors’ new expectations in terms of risk management.

“Smart Beta is growing very quickly. A lot of it is people moving from actively managed funds and traditional passive approaches and we see no let-up in the assets that are flowing towards this,” says Nick Motson, Associate Dean, MSC program, Cass Business School. According to figures from Morningstar, assets under management in Smart Beta funds are on track to hit $1 trillion by the end of this year.

For investors, research has shown clear benefits. The Cass Business School carriedout a study comparing how non cap-weighted strategies would have performed compared with traditional index weighted ones from 1968 to 2011. It found all of the Smart Beta exposures provided a better risk-adjusted return. 

“It’s a way to be fully exposed to equities with the objective to reduce the risk that is going to cut into the performance,” explains Bruno Taillardat, Global Head of Smart Beta and Factor Investing at Amundi, a French asset management firm with more than €1.59 trillion under management.  Traditional equity funds typically allocate money to companies based on their market capitalisation. As a result, a large company will get a larger weighting, even if other pointers dictate that it may be overvalued. Diversification in these traditional funds has come from combining sectors, or geographies that will perform differently according to the prevailing economic cycle. Smart Beta and Factor Investing solutions diversify differently, tilting exposure towards ‘factors’ that have been proven historically to capture risk premia. These factors can include dividend yield, price momentum, volatility and the relative value to peers, and each will perform differently depending on market and economic cycles.

By combining these different factors, it’s possible to create a highly diversified portfolio that can be tailored to fit a broad spectrum of investment objectives. For example, a portfolio of value stocks, which hold the potential for higher growth, but also higher risk, can be balanced with shares in companies that have historically been shown to have low volatility, providing a defensive hedge. “It’s perhaps best used, using a multi-diversified factor approach that can then enhance returns,” says Richard Dell, Global Head of Equity at Mercer, a global consulting firm.

Smart Beta and Factor Investing are based on an objective set of investment criteria, providing a high level of transparency for the investor. They can also provide the groundwork for a bespoke investment solution, for example for an investor whose concern may be to maintain a low carbon footprint, or abide by ethical and social governance criteria. At present, the majority of Smart Beta funds are linked to the equity markets, although the same rationale can equally be applied to fixed-income. Investor concerns about low yield, volatility fears and credit risk all provide fertile ground for the expansion of Smart Beta and Factor Investing bond products.

“Factors should be seen as a way to better diversify the different assets, so no longer focusing only on equities but also trying to find the best instruments in fixed income or other asset classes,” says Bruno Taillardat. With investors embracing strategies to focus on risk to enhance performance, Smart Beta and Factor Investing have taken root as a thriving sector in the equity fund management universe... and which now have other asset classes in its sights.