'Beyond beta': better than 'smart'?

"Smart beta" is generating more and more traction as an investing category at the same time that the label continues to raise the hackles of the investing cognoscenti. (Once a strategy deviates from a traditional passive approach, doesn't it become active by definition?) A clever marketing conceit, the smart beta terminology is perhaps now too firmly entrenched to dislodge. There is, however, value in considering how we might better characterize this fast-growing product set – perhaps with a label that can encompass an even broader range of emerging products that tweak traditional passive approaches. No question that smart beta as currently defined has become a substantial category. As of June 30 last year, Morningstar Inc. was tracking 673 “strategic beta” exchange-traded products globally, representing $396 billion. The U.S. market accounted for nearly 60% of the products and $359.7 billion, or more than 90% of the category's worldwide assets. Yet the term remains problematic, to the extent that it is fostering, even inadvertently, the notion that some beta is “good” and some “not so good," particularly among investors finally embracing the principle that alpha/active and beta/passive is not an either/or proposition but rather a highly effective combination. THE CASE FOR 'BEYOND BETA' There is another, arguably better, way to talk about the category. We prefer the term “beyond beta” — and believe that it can help support a truly coherent, sensible and beneficial discussion with clients about how to extend their application of beta. “Beyond beta,” reinforces the principle that traditional alpha and beta, far from mutually exclusive, need to co-exist on the spectrum of options always under consideration and implementation by the adviser and client. In that sense, beyond beta is not "better than beta" but rather another category on the spectrum. Beyond beta can include a broad range of beta products incorporating a degree of “action” that can deliver value in addition to the market exposure that pure passive products typically provide. The powerful case for the paired benefits of traditional active and passive, alpha and beta is hard-won ground that we're loathe to undercut, even incrementally. Beyond beta can help conceptually safeguard that position. The ongoing proliferation of products that take pure beta to another level definitely offers ample opportunity for advisers to provide valuable, clarifying guidance. The marketplace has most typically construed smart beta to mean so-called "factor-tilted" portfolios, an increasingly utilized and diverse product set. These products attempt to explicitly increase a portfolio's exposures to certain well-known excess return-generating investment styles, or “factors.” For example, a strategy may overweight stocks with lower price relative to fundamental value measures or stocks with meaningful price momentum. FACTOR BASED These factor-based strategies owe a considerable debt to the pioneering work of leading academics such as Eugene Fama and Kenneth French (of the University of Chicago and Dartmouth College, respectively) who generated profound new insights into the most fundamental, key drivers of investment return. Such research has found that certain factors persistently generate a significant excess return, or risk premium, over a market cap-weighted index. Factor-tilted products seek to systematically capture such "risk premia" and, in fact, the performance of portfolios with active weights to these factors has lent considerable support to the case. However, a beyond beta strategy also can be executed in at least one other way, by offering "personalization" features to a traditionally passive index strategy. For example, an index replication strategy can be accessed through a separately managed account in order to readily generate tax management value, or to easily screen out certain holdings in recognition of positions held elsewhere or concerns about socially responsible investment. Such products, while rooted in an index, can be easily tailored to meet client needs, objectives and personal convictions. All of these products — from the straightforward to the more esoteric — offer the adviser a chance to reinforce and extend the long-term portfolio benefits of intelligent and careful diversification. Beyond beta as a concept can help shape the client's understanding of the role and benefits of such products, implicitly suggesting as it does that, complex or not, they simply occupy another line on the investor's extensive menu of choices — alpha/active, beta/passive and beyond — for optimal asset allocation. As with any category, emerging or established, due diligence is vital. Not all such products are created equally, and they will inevitably perform differently under various market scenarios and conditions. Advisers ultimately are well served by becoming comfortable, at least in broad strokes, with the methodology and process underlying the design and behavior of competing products — at the same time that they're taking care to translate such attributes into readily appreciated portfolio value for clients. Brandon Thomas is chief investment officer at Envestnet | PMC.