Smart-beta strategies attempt to provide better risk-adjusted returns by using measures other than market capitalization to weight portfolio holdings. Historically, these alternative weightings have produced higher Sharpe ratios, a measure of return per unit of risk, and this is why they've earned the "smart" moniker in the view of their advocates.
Smart-beta strategies can be considered as occupying the middle-ground between active and passive investing, with rules-based methodologies (like passive investing) that nevertheless deviate from broad market benchmarks (like active investing). Distinct smart-beta strategies and funds can either be "single factor" or "multi-factor," as explained in Lazard's December 2015 Letter from the Manager: A Better Kind of Beta, which reviews five such "factors" before going on to make the case for multi-factor investing in general, and Lazard's own multi-factor strategies in particular.
A "factor" is any consistent characteristic that academic research has shown explains the risk or return characteristics of stocks. Common style factors include:
- Value - Value-investing is championed by the most successful investor of all time: Warren Buffett. But "value" can be defined in a number of ways, and not all measures are as likely to produce superior results. In Lazard's view, a combination of "cyclical" (such as price-to-book) and "defensive" (such as cash flow) measures provides the most consistent exposure.
- Momentum - Stocks going up tend to continue going up - and vice-versa. At the same time, what goes up must come down - the question is "when?" Lazard recommends using measures other than simply price momentum to judge market sentiment - including macroeconomic data releases.
- Low Volatility - Low volatility stocks have added appeal in the wake of the financial crisis, but Lazard thinks this factor can best be exploited not by allocating specifically to low-volatility stocks, but by targeting low volatility in portfolio construction. Lazard's process identifies low-volatility companies with attractive fundamentals.
- Quality - Lazard's take on "quality" compares a company's (paper) earnings and (actual) cash flow. Accounting rules and the market's short-term focus may put undue emphasis on the former, whereas an analysis of a company's cash flow may provide a more accurate estimate of its earnings strength.
- Growth - While "momentum" is a growth measure determined by share price, the "growth" factor considers a company's financial statements. Lazard's approach is designed to identify stocks that are well-positioned to experience above average growth in the future.
Multi-factor investing offers the advantages of diversification and flexibility. Although individual factor indexes have outperformed since 1988, returns are cyclical and different factors outperform at different times. Diversified multi-factor investing thus works to mitigate volatility, which can limit account drawdowns. Multi-factor investing also promises the benefit of flexibility, wherein outperforming factors can be emphasized. Single-factor and passive cap-weighted investing has no such flexibility.
Lazard boasts of its own "multi-factor pedigree," with "a set of balanced style criteria" that have been researched and refined over the past two decades. The firm has been implementing multi-factor approaches in live portfolios over the entire in period, in a variety of global-, regional-, and country-specific scenarios. In fact, Lazard was doing smart beta before smart beta was even known as smart beta - Lazard used to call it "quantitative" or "systematic" investing.
"Not all smart-beta strategies are created equal," according to Lazard, and in the firm's opinion, exposure to several factors provides far greater consistency of performance over both the long- and short-term. Lazard's own multi-factor strategies have "the benefit of the skill and long-standing experience" of the firm's multi-factor selection, combination and diversification, as well as ongoing research and risk monitoring.
For more information, download a pdf copy of the letter.