Factor indices – a smarter name for smart beta

Smart beta (also referred to as advanced beta and alternative beta) indices have gathered a lot of attention recently. It is surprising that rather than describing what they are, they are defined by what they are not: ie indices not weighted by market capitalisation.

There is a lot of confusion over what these benchmarks are, how they should be used and the volume of assets tracking them. Indices such as equal weight, fundamental, value, momentum, quality and minimum volatility all use factors to reconfigure standard market-cap indices into smart-beta indices – a more accurate term might therefore be “factor indices”.

Although smart beta is a catchy term from a sales and marketing perspective, it is not derived from the statistics of alpha and beta and it is unlikely that managers running a FTSE 100 or similar index strategy would like to be referred to as managing “dumb beta” portfolios.

American economist William Sharpe first used the terms alpha and beta 50 years ago to describe the risk ratios used to measure investment returns. Alpha is the excess return of an investment above a benchmark like the FTSE 100, while beta is the non-diversifiable risk of a market and by default has a value of 1.0. It is expressed as the volatility of returns compared to a benchmark, such as the FTSE 100.

A fund with a positive alpha of 1.0 has outperformed its benchmark by 1% while one with a negative alpha of 1.0 would indicate an underperformance of 1%. A beta greater than 1 means the fund is more volatile than the FTSE 100, while a beta of less than 1 indicates less volatility.

Academic research has demonstrated flaws in market-cap-weighted indices, which weight stocks according to a company’s size as reflected in the share price, and has illustrated alternative approaches to indexing that provide better returns with lower risk.

Historically, investors decided whether to employ active or index strategies. Most would prefer to receive alpha performance from their investments but have discovered it is hard to find funds that consistently deliver this, as typically six or seven out of 10 funds do not beat their benchmark most years.

The appeal for many is that smart beta indices have historically produced long-term outperformance relative to market-cap indices. The proposition is to avoid the flaws in market-cap indices and avoid active funds, which do not consistently deliver alpha. Many large asset managers have announced that they plan to focus on offering smart-beta strategies and smart-beta ETFs have been launched, with many forecasting them as drivers of new assets.

There was $142 billion invested in these strategies at the end of the first quarter of 2013, according to estimates from State Street Global Advisors. Net inflows into these strategies over the past three years were $81.6 billion, of which $66.2 billion went into ETFs with the remainder going into mutual funds. Expectations are high with forecasts that the assets in these strategies will grow in the next five years to account for 30% of passive equity, or about $6 trillion.

There is no magical formula that will always deliver better than market-cap returns. Smart indices are built using various factors that will create biases, of which the investor must be aware. Equal-weight indices have a small-cap bias while fundamental indices have a value bias. These biases are the reasons that the indices perform differently than market cap.

The term smart beta may be misleading as many of these indices have had significant multi-year periods of underperformance compared to market-cap indices. There are also significant differences in the performance of different indices.

These new indices are useful tools for many investors but to provide better transparency on what they are – the biases and drivers of risk and returns – we believe the label factor indices describes them better than smart beta.