January brings plenty of resolutions along with forecasts. I’ll spare you the details of my renewed commitment to kale and cardio fitness and instead focus on what the year ahead could look like for one of the most talked about investment ideas ―smart beta.
Investors and advisors alike are becoming intrigued with an approach that combines elements of passive and active investing and can potentially outperform a typical index strategy. It’s a different way of thinking about investing, focusing on the true drivers of risk and return and putting them together in a way that’s designed to create better outcomes.
Here are my top five predictions for smart beta as it continues to mature in 2015:
- Less arguing, more action
At the last industry conference I attended, I counted six (six!) different panels on the topic of smart beta. That’s the great news. The bad: Almost every panel and press article gets mired in a discussion of the name—Do you like it or hate it? Is it always smart? Is it really beta?
Enough already! This pedantic focus on the name distracts from the fact that smart beta might just be one of the most meaningful developments in the investment landscape of this decade. So let’s stop arguing over whether or not it’s “smart” or whether or not it’s beta and start talking about how it has the potential to improve investment outcomes.
This year, I predict we’ll see more agreement on common classifications for the category that describe how different types of smart beta can serve different purposes. This will help investors compare and contrast smart beta strategies and the role they might play in their portfolios.
- Smart beta gets some respect
Along with ceasing the name game, I’d also like to call a halt to the active/passive debate. Purists would argue that smart beta is neither active nor passive—and I’m inclined to agree. It’s simply smart beta—including elements of both active and passive investing. This year, I predict that investors will increasingly recognize smart beta as its own asset class and consider an allocation alongside their existing active and passive investments.
- Moving on to SB 2.0
The earliest and most widely adopted forms of smart beta have been equity index portfolios that are weighted by factors such as price to earnings or dividend yield, rather than by traditional market capitalization. While these index-driven strategies, often delivered in the form of exchange traded funds (ETFs), can help enhance returns or reduce risk, smart beta doesn’t end there. How can we deliver exposure to a particular asset class in a way that improves diversification and risk adjusted returns, or takes advantage of known market anomalies? This is smart beta. This year, I predict investors will continue to embrace equity index versions of smart beta, while also exploring the potential for more outcome-oriented strategies in other asset classes. Which brings me to prediction number four…
- Joining the hunt for yield
The search for yield is perhaps the biggest challenge investors face in today’s interest rate climate. Reaching into longer dated securities to boost income is increasingly difficult to stomach, even with Federal Reserve Chair Janet Yellen promising to keep interest rates low for longer. Traditional fixed income indexes are currently biased toward longer term bonds, a bias that can hurt investors if rates rise, and have the largest exposures to companies or countries with the greatest amount of debt, potentially increasing credit default risk. Yet, simply reducing duration or credit exposure could erode the yield that investors so avidly pursue.
One way to diversify traditional fixed income investments is to consider strategies that shift away from highly indebted companies and offer a balance between interest rate and credit risk… while still providing an attractive yield. This year, I predict that we’ll hear a lot more about smart beta in fixed income as an attractive alternative to traditional passive bond indexes. (I’ll discuss fixed income smart beta in more detail in my next post.)
- The resurgence of Min Vol
Minimum volatility strategies were among the most popular forms of equity smart beta that attracted fervent attention in the wake of the credit crisis. Minimum volatility strategies seek to decrease the effects of the market’s ups and downs over time by providing equity investors lower risk alternatives to traditional equity portfolios. These funds enjoyed a rapid rise in fame, gathering an estimated $9.1 billion in net ETP flows in 2012 and 2013 (Source: Bloomberg). Since then, attention has waned. After three consecutive years of double-digit equity market returns (Total gross return for S&P 500 Index from 12/31/2011 – 12/31/2014) there was less focus on the need for downside protection.
However, over the last several months market volatility has returned with a vengeance—a function of changing monetary policy in the U.S. and a plethora of geopolitical risks popping up around the globe. In this environment of increased uncertainty, I predict that minimum volatility strategies will re-enter the spotlight as a way for investors to maintain equity exposure while seeking less risk.