Multi-Factor Smart Beta as an Investment Strategy

by Fairtree Capital

A Global Wave of Change

The rapid growth of the Smart Beta investment industry over the last decade has been nothing short of extraordinary. Morningstar (2015)1 reported that assets under management have more than doubled since 2012, with investors globally realizing the potential of informed passive investment strategies. Smart Beta, systematic- or factor investment products are solidly grounded in the scientific method and Nobel-prize winning academic literature. It harnesses the latest developments in computing power, combined with the wide availability of data, to create an investable product that boasts the intuitive information content of an active investment product with the low cost and transparency of passive solutions.

1 Morningstar “A Global Guide to Strategic-Beta Exchange-Traded Products”, (https://corporate.morningstar.com/US/documents/Indexes/Strategic-Beta-Landscape.pdf)

Swimming with the tide

To put the power and potential of Smart Beta into relative perspective, consider this simple analogy of a shoal of fish swimming along a sea current. Storms, the tides and strong winds have an effect on the current, and thus the speed of the fish inside the current. Within the shoal, however, there are certain characteristics that determine the relative speed of the individual fish, such as, e.g. length and weight.

Similarly, all the stocks on the JSE (the market) are affected by economic storms, such as global crises, and strong winds, such as quantitative easing. Within the market, however, there are also certain characteristics that determine the relative returns of the stocks, such as e.g. Quality and Value. These intuitive and attractive features are commonly used by seasoned investors such as Warren Buffett and Benjamin Graham.

Applying the analogy further, passive investment strategies could be likened to buying and holding the entire shoal of fish. Whilst this is considered a safe, low-cost strategy, the inefficiencies are clear in that investors hold both slow and fast fish in equal measure, with no use of the available information (such as individual weights and lengths). In contrast, active investment strategies set out to find only a few of the fastest individual fish, but often do so inefficiently and at a higher cost.

This is where Smart Beta solutions offer an attractive middle-ground, as it seeks to identify and hold only the fastest type of fish, in a transparent and systematic way. This is done by focusing on the identification of those characteristics that are correlated with the speed of a fish. Similarly, certain measurable stock attributes have been identified in academic literature and have been empirically proven to be correlated with future stock returns. By systematically applying an investment process to identify such characteristics, Smart Beta solutions offer a defensible and consistent investment approach, at costs comparable to passive strategies.

Why Invest according to Factors?

Conceptually, the motivation behind investing in a Smart Beta solution is the same as the motivation for investing in the stock market (as opposed to putting your money under the proverbial mattress); over the medium to longer term, investors expect to earn an additional reward for doing so. Similarly,

Smart Beta portfolios seek to further improve the process of equity investing by identifying the factors or characteristics that pay such an additional premium:

Few would argue that this intuitive strategy of picking the most profitable and efficient stocks (Quality) with attractive valuations (Value), where the market is starting to realise the potential (positive Momentum) and has shown consistency and stability (Low Volatility), is not prudent.

Smart Beta solutions, in fact, use largely the same information as active managers to 2 yet incorporate this wealth of financial statement and pricing information in an efficient and systematic way into investable solutions, at low fees.

2 See, e.g., interesting studies done by Mladina & Coyle (2010) and Frazzini, Kabiller, Pedersen (2013), which show active managers typically have high exposure to systematically identified factors.

•INVEST IN THE BEST

•COMPOUND MORE BY LOSING LESS

•DON’T FIGHT THE TREND

•BE AWARE OF THE PRICE YOU PAY

VALUE

MOMENTUM

QUALITY

VOLATILITY

Conclusion

A Smart Beta multi-factor approach offers a systematic solution to the efficient transformation of information into investment decisions, based on a well-researched, transparent and consistent set of theoretically and empirically defensible factors. And if the US investment industry remains an indicator of future developments in South Africa, we should expect to see the rise of such low-cost, informed-passive investment solutions on the domestic front, ultimately to the benefit of the consumer.