Kei Sasaki, CFA, Northeast
Dave Roda, CFA, Southeast
Sean McCarthy, CFA, Southwest
Marc Doss, CFA, CA & Nevada
Cam Hinds, CFA, Great Lakes
Michael Serio, CFA, Mt. Northwest

In this Monthly Market Advisor:

  • Quantitative investing is a broad discipline that has become more widely associated with a concept known as “smart beta.”
  • The rapid growth of smart beta is leading more of the investment community to evaluate its merits as it relates to delivering value for investors and sustainability. 
  • A look “under the hood” of smart beta can reveal both opportunities and potential risks of adopting such a systematic investment discipline.
  • Investors may benefit from smart beta strategies in numerous ways and gain new insights from their underlying quantitative factors but should recognize their limitations.

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An often heard cliché is that investing is “more art than science.” Try getting that past a quantitative investor or a “quant!” At its core, quantitative investing seeks to eliminate the art. Unlike traditional fundamental investing, it applies a systematic, factor- and rules-based approach. However, it is similar to fundamental investing in that quantitative investment strategies tend to be managed against a traditional market benchmark index. Quants seek objectivity, which theoretically allows them to look past headline distractions. Now becoming more mainstream, quant asset managers have introduced a variety of strategies, many of which are being positioned as being superior to strategies that track capitalization-weighted benchmark indices, under the branding of “smart beta.”

Smart beta is a quantitative investment strategy that seeks to identify and invest in measurable factors (such as momentum or value) that appear to have a strong likelihood to enhance returns based on historical, backtested data. This raises an important question: Is smart beta simply tracking a subset of the market, trying to redefine the market, or is it trying to beat it.

The Origins of Quantitative Investing

A quantitative investing approach can provide a well-defined framework to help asset managers navigate through an emotion-prone market environment. With effective application, managers can enhance consistency in execution and lend to confidence behind expectations for risk and return. Also, it can help expand beyond return and risk objectives through the targeting of a variety of factors. 

Quantitative investing has quite a long history. The idea of using quantitative factors appeared in the works of academics like Benjamin Graham and David Dodd, who identified the importance of quantifying the “value” factor to assess attractiveness of an investment. As capital markets expanded and became further developed, more factors became identified and applied. William Sharpe, father of the Capital Asset Pricing Model (CAPM) and a key person behind the “revolution in portfolio management, which got its start at Wells Fargo,”  applied the “market risk” factor and stressed its importance to valuation and diversification. Professors Eugene Fama and Kenneth French expanded on the CAPM model by introducing “value” and “size” factors alongside Sharpe’s approach.

The Passive Movement, Big Data, and the Rise of Smart Beta

At the time of this writing, the U.S. large-cap equity market was over eight years into a bull market, the second longest on record. As this market run extended, various headwinds began to emerge, like episodic volatility, rising costs and fees, and lackluster investment performance. These headwinds helped to drive the “passive” movement. Based on data through March 2017 compiled by Morningstar, there are about $4 trillion of passively managed exchange-traded funds (ETFs) listed worldwide, up from $1 trillion at the end of 2009. This is in sharp contrast to the net outflows from “active” funds over this period.

In recent years, quants have sought to enhance passive investing through “Big Data,” the massive accumulation and processing of data. According to a recent report by IBM, over 2.5 quintillion (that’s 30 zeroes) bytes of data are created daily and over 90 percent of the world’s data was produced in the last two years.  With the continuation of technological proliferation and education, the expansion of data is likely to continue accelerating. With this development, smart beta’s mass market penetration and entrance into the mainstream has begun.

Smart beta has its roots as an institutional solution. As it has grown in popularity, more companies are entering the field. Accompanying the new entrants is a diner-like menu – advanced beta, alternative beta, enhanced beta, strategic beta, and so on. For purposes of this paper, we refer to smart beta as the broad categorization of strategies that do not use market capitalization to weight index components.  

Rising demand for smart beta is very real. According to Morningstar data, since the end of 2009, smart beta assets have grown over 506 percent. As shown in Chart 1, this dwarfs the overall ETF universe growth of 220 percent.

Chart 1: Assets-Under-Management (AUM) Growth of Smart Beta ETFs versus Overall ETF

Chart depicting that smart beta assets have grown over 506 percent since 2009, which dwarfs the overall ETF universe growth of 220 percent.

Source: Morningstar, Wells Fargo Investment Institute Global Manager Research, May 2017

Information on assets provided by Morningstar and includes all worldwide domiciled ETFs. Note that the Morningstar definition of smart beta is broad and includes products tied to benchmarks that first screen candidates for a variety of attributes (value, growth, and dividend characteristics, for example) and subsequently weigh the eligible securities by their market capitalization as well as products that do not weight constituents by market-capitalization at all but use some other criteria to weight component, e.g., volatility, dividend payout, book value, factor-based, and equal-weight methodologies. Non smart beta ETFs are any ETFs that Morningstar does not consider smart beta. These ETFs seek to track an index whose components are weighted by market capitalization.

An important point to note, smart beta strategies are ultimately a subset of the much broader quantitative investment discipline. Many of today’s smart beta strategies reflect the vast improvements that have been made in collecting and analyzing the ever-increasing sets of market data, and applying it to enhance asset selection, portfolio construction and risk management. In summary, the rise of smart beta can be attributed to five key things: Big Data, better technology, rising fees and costs, performance frustration, and more accessibility. With these drivers, we believe the smart beta trend will likely continue.

Looking Under the Hood: Exploring Smart Beta Mechanics

In general, smart beta managers claim objectivity toward traditional market cap weighted benchmark market indices, like the S&P 500 index. However, in many cases, smart beta strategies are expected to outperform these traditional benchmarks. In other words, smart beta strategies, along with their respective “enhanced” market benchmark indices (i.e., equal-weighted, fundamental-weighted), are collectively positioning themselves as a new market standard. Also, with an expectation of outperformance versus a benchmark index, by definition, smart beta strategies are very much active.

As mentioned, smart beta identifies opportunities by analyzing factors. There are an endless number of factors, but the more common ones are seen in Figure 1. Factors are measurable and can serve as signals for identifying fundamental trends. For instance, by examining which factors are contributing to portfolio or market returns, the managers hope to deduce which fundamentals are working. Through such analysis, their aim also is to preemptively identify what risks might be emerging and in concert, create and manage portfolios based on these factors. Thus, a primary goal of smart beta is to help improve the ability to achieve return and risk objectives simultaneously.

Figure 1: Different Types of Smart Beta Factors

Image describing different types of smart beta strategies, which include return oriented, risk oriented, and others.
Source: Wells Fargo Investment Institute Global Manager Research, May 2015

As with any investment strategy, there are risks associated with smart beta. Many of these strategies target consistent- but-modest excess returns. Thus, when a factor identified in their quantitative model appears disproportionately attractive, the rules-based process risks being overridden by human intervention. In these instances, it is possible to “over tilt” to certain factors. If many other smart beta funds take a similar approach, this is akin to overcrowding a single stock. Factors are like individual asset classes: they follow cycles. Thus, there are great risks that can come with attempting to “time” a factor. If an over-tilted factor falls out of favor at some point, the exodus from that factor can be seismic, as witnessed during a sharp and substantial quant drawdown led by an overcrowding of value factors during 2007 and 2008.

Also, it is important to acknowledge the “black box” and backtesting shortcomings. The success of these strategies is dependent on the quality of the factors that are used. As the demand for smart beta strategies grows, there is a greater likelihood of managers entering the competitive arena. As such, it is important to have a clear understanding of how the smart beta strategy is constructed and managed, and what factors are being used. As mentioned, if a particular factor becomes popular and used by many managers, it can compromise its return potential. Also, it is important to understand how backtesting of data has been performed and how these past trends might, or might not, extend into the future

Conclusion: Investor Application

When considering investing in smart beta, it is critical to first have clarity behind what the “smart” factors are trying to achieve. Is it to outperform the market, risk management, or both? Is it attempting to provide a more targeted market exposure, such as yield enhancement? Whatever factor exposure an investor in a smart beta strategy is seeking, it is prudent to stay true to one’s overall investment objectives and philosophy. From there, smart beta investments can be aligned within the context of the overall portfolio. For instance, if an investor seeks to target income or fundamental-based factors, the smart beta strategy would need to be aligned to those characteristics. As mentioned earlier, various ETFs offer an accessible means to gain smart beta exposure and could serve well to provide an objective means to achieve that alignment.

Ultimately, one must be cognizant of the markets’ ability to recalibrate the relative attractiveness of any type of investment. In other words, an attractive factor today could quickly fall out of favor tomorrow. Without proper due diligence and clear alignment with one’s investment objectives, smart beta can easily become dumb.

1 Bernstein, Peter L., Capital Ideas: The Improbable Origins of Modern Wall Street, 2005
2 IBM and Watson Marketing, 10 Key Marketing Trends for 2017, December 2016
3 Wells Fargo Investment Institute Global Manager Research, Smart Beta: A New Paradigm for Investors, May 2015