Global take-up of smart beta as an investment strategy is at a high. Scottish Widows explains these strategies and their potential to generate returns and reduce risk relative to traditional indices.
Fourteen years after smart beta pioneer Research Affiliates launched its first smart beta index, global adoption of smart beta has reached a record high as asset managers recognise its potential benefits as an investment strategy with potential to generate returns and reduce risk relative to traditional indices.
Research Affiliates introduced the RAFI Fundamental Index™ in 2005 and partnered with the FTSE Group (now FTSE Russell) to launch FTSE RAFI indices that year. FTSE Russell Smart Beta Global Survey 2018[1] (which canvassed 185 global asset owners accounting collectively for more than $2 trillion in assets under management) found that smart beta adoption rates among respondents reached a record high of 48% in 2018 - up from 26% in 2015.
Asset managers cite their top three reasons for adopting smart beta strategies as: risk reduction, return enhancement and improved diversification, with cost saving coming fourth.
Generating additional returns for investors was a prime factor in Scottish Widows' decision in 2013 to transfer more than £2 billion into smart beta strategies with three new Scottish Widows' funds tracking the FTSE RAFI index series. It ranked as the largest single investment mandate from a UK institutional investor into the FTSE RAFI series and put Scottish Widows in the vanguard of smart beta adoption both in the UK and globally. We continue to use smart beta strategies across our range of multi-asset portfolios, notably within the Premier Pension Portfolios.
What is smart beta?
Smart beta strategies emerged from academic research into the ‘Efficient Market Hypothesis', which established that a number of rules-based investment styles could help boost investment returns while maintaining - or even reducing - the overall level of market risk for investors.
Smart beta differs from the traditional market-capitalisation-weighted approach of most major equity indices. Smart beta strategies effectively track different types of indices, which are weighted according to specific factors.
These factors can vary, but the most popular smart beta strategies are: fundamental, which weights stocks on factors such as sales, cash flow and dividend yields; equal weight, which allocates the same weighting to all index constituents; low volatility, which weights stocks according to volatility over a set time period; momentum, which weights stocks according to price momentum over a set period; and quality, which weights stocks according to measures such as a strong balance sheet, consistent sales and measures of profit (e.g. return on equity) .
Appropriate use
Smart beta is often considered a hybrid of passive and actively managed approaches, offering a ‘third way' to asset managers. Scottish Widows uses smart beta strategies selectively, taking fund aims, cost structure and risk profile into account when deciding on which circumstances, and in which funds, smart beta strategies may be appropriate and potentially beneficial. For example, the smart beta indices that we use within the Premier Portfolios use a fundamental indexing strategy (two are combined with low volatility) and they have made a positive contribution to performance over the last three years.
Smart beta is neither a panacea nor the only answer: a traditional market-capitalisation-weighted approach has its own advantages and has delivered excellent returns for investors over the last decade. Where cost allows, however, we believe that there can be advantages to adopting smart beta as an alternative form of index tracking.
The next wave
Multi-factor, index-based equity strategies are currently the most widely adopted smart beta strategies, according to the FTSE Russell survey. It is not widely appreciated that there are smart beta fixed income strategies too; adoption rates are low, however, compared to equities with just 9% of the 185 asset managers who responded to the FTSE Russell survey using smart beta fixed income strategies.
As to future trends, there is growing interest in smart beta strategies taking into account environmental, social and governance (ESG) considerations - more than half of asset managers in the FTSE Russell survey are currently implementing or evaluating ESG considerations in their investment strategies.
Research Affiliates has capitalised on this with the launch last March of an ESG smart beta strategy that takes into account a number of ESG factors, while October saw the launch of the RAFI Diversity and Governance smart beta strategy that integrates gender and diversity data as well as governance and financial discipline metrics. As smart beta enters its ‘teenage years', there are signs that it is evolving and maturing into a multi-faceted investment strategy.
