Smart Beta 2

  • Investment Insights
  • 5 minute read

Last month, we wrote that the Passive market is now worth more than $5 trillion globally1, and that Smart Beta is growing in popularity. This month we’ll dig deeper and explore some of the questions we posed. First a quick recap on what Smart Beta is and why we use it in our Close Tactical Select Passive (TSP) fund range.

What is Smart Beta or Factor investing?

For us, Smart Beta is 'factor investing' and we use these terms interchangeably. We loosely define it as any strategy with a strong academic methodology which attempts to isolate particular market characteristics. It gives an investor a broader set of asset allocation tools.

Why use Smart Beta?

Reasons vary, but we might look to outperform an index, seek lower volatility investments or to isolate high dividend yielding stocks or a sector, such as US financials. It’s important to note that an ETF may be multi-factor, i.e. its methodology might seek value-oriented equities (by P/E) and high dividend yielding stocks. Smart Beta helps us to express our Tactical Asset Allocation (TAA): if we are bearish, we might seek high dividend and low volatility factors; if we are bullish; value, growth or momentum stocks might be preferred.

Will the addition of a Smart Beta fund in our portfolios actually deliver the returns and experience we anticipate?

There are several layers to this question: first, whether our interpretation of how an ETF might reflect our TAA played out as we anticipated; second, whether the ETF’s model worked; third, whether timing (both of our TAA call and our choice of ETF to express it) was optimal; and finally, whether the ETF had enough time to deliver during the duration of a TAA call.

Attempting to forecast volatility (which for our clients ultimately means what investing feels like) is the subject of rigorous academic research and debate, and there is no set reliable approach. If we cannot reliably forecast, we must rely on ex-post facts: what was our actual experience? Ultimately, there are so many variables that we focus on risk-adjusted returns at portfolio level. The Sharpe Ratio is most commonly used.

Is the ETF’s methodology proven?

This is easier to ascertain. Either we have several years’ data to analyse and get comfortable with before buying an ETF (real experienced investor returns); or we can use back-test outcomes as Smart Beta/Factor ETFs are rules-based. However, in reality there are a myriad of factors that will ultimately impact whether or not an ETF is successful; none more so than macro-overlay and market timing.

In which markets might a strategy not work?

In 2016/17 we conducted extensive due diligence on low volatility ETFs with US market exposure in US dollars. We anticipated that however robust an ETF’s methodology, its returns and more could be erased by the currency volatility of an unhedged strategy. Sterling indeed crashed in value against USD and EUR after the Brexit referendum. The ETFs we looked at worked in USD terms, but ‘failed’ from our Sterling-centric viewpoint. Whether Sterling weakness was structural or cyclical, remains to be seen.

How do we think about the intended and unintended consequences of using Smart Beta ETFs?

At the outset, our intention is always to use Smart Beta intelligently to express our TAA in an active-passive way. Smart Beta ETFs are more expensive than conventional passives and there is a limit to how smart one can get by titling a portfolio in this way. Costs detract from performance (all reported performance is net of fees, of which fund charges are the bulk) and costs are a relentless focus of ETF investors, not to mention the broader market.

So as you would expect, we closely monitor the performance and volatility of ETFs in the TSP fund range, to ensure that in risk-adjusted terms, and against our peers, we continue to deliver. Smart Beta ETFs are a central part of our portfolios and without them it would be much harder to reflect our TAA. It is the incremental value of all of these decisions which we believe adds value to our clients’ experience and returns during a market cycle.


1Citi Research: Riding the Passive Wave, with kind permission 27.02.2019.

Important information
This article is only intended for use by UK investment professionals and should not be distributed to or relied upon by retail clients.  The value of investments will go up and down and clients may get back less money than they invested. Past performance is not a reliable indicator of future returns. The information contained in this document is believed to be correct but cannot be guaranteed. Opinions constitute our judgment as at the date shown and are subject to change without notice. This document is not intended as an offer or solicitation to buy or sell securities, nor does it constitute a personal recommendation.


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