Is smart beta a smart investing idea?

Passive investing has long been the norm for many investors, but there is growing concern that following the…

Passive investing has long been the norm for many investors, but there is growing concern that following the market may be too risky in certain environments.

Markets fluctuate between boom and bust cycles. Concentrations in the market build up, then collapse.

Examples include global banking and real estate stocks in the 2000s, technology stocks in the 1990s, Japanese stocks in the 1980s — the list goes on. These cycles can cause both passive and active strategies to become dangerously concentrated in a just few stocks, sectors or countries.

In reaction to this, financial advisers and their clients have become increasingly invested in a third style of asset management, often referred to as “smart beta,” which falls somewhere between the active and passive paradigms.

$100 billion market

Morningstar Inc. estimates that the assets under management of U.S. smart-beta exchange-traded funds are approaching $100 billion.

That includes about $19 billion in inflows over the first half of 2013.

Smart-beta strategies often are used as a replacement to a pure passive-capitalization-weighted portfolio or as a complement to existing passive and active strategies. There are a broad range of strategies, including minimum volatility, equal-weighted and fundamentally weighted strategies, among others.

Although the strategies use very different methodologies, they all are focused on portfolio construction as the primary source of value. Smart beta relies on three basic tenets: no fundamental views are expressed at the security level, outperformance is based on the structure of a rules-based portfolio, and portfolios are constructed in a transparent fashion.

Diversification works to ensure that the portfolio weights are spread across many different investments. The extent to which the investments are “different” implies that they are uncorrelated with one another, which in turn helps to lower volatility risk.

Smart-beta strategies typically seek to capture market returns with less risk and are based on the concept that one must diversify and re-balance a portfolio systematically. A number of academic and practitioner articles have shown how rules-based processes can derive significant outperformance over time.

Merely being published in an index isn’t a credential of good management. Advisers and investors are obligated to perform due-diligence research on any strategy they recommend for clients.

In addition to the regular due-diligence questions that should be asked of any active strategy, advisers should ask the following questions when examining smart-beta strategies:

• How much tracking error risk does the strategy take? Some smart-beta strategies are very close to the capitalization-weighted benchmark tracking error of 1% to 2%, while others can be as aggressive as the most active of fundamental managers, with 8% to 10% tracking error.

• Is the portfolio volatility reduced relative to the cap-weighted benchmark? When markets are down, the strategy tends to outperform, just when investors need it most.

• How concentrated is the portfolio? It is all well and good to have lower volatility, but if the portfolio is concentrated in a few stocks, sectors or countries, it is hard to argue that the portfolio has achieved meaningful diversification.

• Who is managing the process? Many of these strategies are formulated as indexes. Who is in charge of enforcing the rules? Is there an experienced investment team? Risk control can help avoid painful market surprises and help ensure that an investment program is maintained during difficult periods.

• How much turnover does the strategy entail? This has an impact on transaction costs and taxes. Transaction and implementation costs often define the difference between success and failure.

Strategies within the smart-beta spectrum need to be carefully evaluated before an adviser makes an allocation to a client’s portfolio. However the possible advantages are substantial, with the potential to provide additional alpha while lowering volatility and risk.

Paul Bouchey is the managing director of research at Parametric Portfolio Associates LLC.