Skip to main content
MENU
Subscribe
  • Sign Up Free
  • LOGIN
  • Subscribe
  • Topics
    • Alternatives
    • Artificial Intelligence
    • Consultants
    • Defined Contribution
    • ESG
    • ETFs
    • Face to Face
    • Hedge Funds
    • Industry Voices
    • Investing
    • Money Management
    • Partner Content
    • Pension Funds
    • Private Equity
    • Real Estate
    • Regulation
    • SECURE 2.0
    • Special Reports
    • Washington
    • White Papers
  • Rankings & Awards
    • 1,000 Largest Retirement Plans
    • Top-Performing Managers
    • Largest Money Managers
    • DC Money Managers
    • DC Record Keepers
    • Largest Hedge Fund Managers
    • World's Largest Retirement Funds
    • Best Places to Work in Money Management
    • Excellence & Innovation Awards
    • WPS Innovation Awards
    • Influential Women in Institutional Investing 2023
    • Eddy Awards
  • ETFs
    • Latest ETF News
    • Fund Screener
    • Education Center
    • Equities
    • Fixed Income
    • Commodities
    • Actively Managed
    • Alternatives
    • ESG Rated
  • ESG
    • Latest ESG News
    • The Institutional Investor’s Guide to ESG Investing
    • ESG Sustainability - Gaining Momentum
    • ESG Investing | Industry Brief
    • Innovation in ESG Investing
    • 2023 ESG Investing Conference
    • ESG Rated ETFs
    • Divestment Database
  • Defined Contribution
    • Latest DC News
    • The Plan Sponsor's Guide to Retirement Income
    • DC Money Manager Rankings
    • DC Record Keeper Rankings
    • Innovations in DC
    • DC Plan Design: Improving Participant Outcomes
    • 2023 Defined Contribution East Conference
  • Searches & Hires
    • Latest Searches & Hires News
    • Searches & Hires Database
    • RFPs
  • Research Center
    • The P&I Research Center
    • Earnings Tracker
    • Endowment Returns Tracker
    • Corporate Pension Contribution Tracker
    • Pension Fund Returns Tracker
    • Pension Risk Transfer Database
  • Careers
  • Events
    • View All Conferences
    • View All Webinars
Breadcrumb
  1. Home
  2. INDUSTRY VOICES
August 11, 2017 01:00 AM

Commentary: Demystifying smart and alternative beta

Philippe Jordan
  • Tweet
  • Share
  • Share
  • Email
  • More
    Reprints Print

    The proliferation of quantitative strategies indicates investors increasingly recognize the benefits of using data and technology and applying a scientific investment approach to generate returns. Advancement of this kind led to the emergence of a "new" beta category and means the investment universe no longer divides neatly into funds that seek alpha or beta. Similarly, the nomenclature used to define the strategies has become indefinite. Unfortunately, the blurring of strategies and terms has led to confusion and frequent conflation of two distinct strategies: smart beta and alternative beta.

    It is critically important the investment community better understands the difference between smart beta and alternative beta because they aim to deliver markedly distinctive risk-and-return profiles and, accordingly, serve different purposes in an investment portfolio.

    This article clarifies the two categories with respect to investment objectives, implementation and fees. The comparative analysis focuses on equity-based strategies, but the arguments presented are asset class agnostic. Ultimately, this comparison intends to help investors make well-informed investment decisions.

    Investment objectives

    Smart beta and alternative beta strategies exploit a similar set of factors, often behavioral return anomalies such as value or momentum, but use them to generate entirely different return streams.

    Smart beta strategies are generally designed to provide exposure to equities with a higher Sharpe ratio — that is, a better risk-adjusted return — than conventional, market capitalization weighted indexes. It attempts to achieve this by constructing portfolios based on factors that have empirically shown higher Sharpe ratios than those using market capitalization. Ultimately though, performance of many smart beta strategies closely correlates with equity markets, and thus much of their risk and return is driven by the market. Figure 1 shows the result based on a set of popular funds.

    Alternative beta strategies, in contrast, are designed to exhibit almost no correlation to equity markets to provide a "pure" exposure to the factor they are attempting to exploit. They should have little to no beta exposure to equity markets and, ideally, target a specific level of volatility that is independent of the volatility of equity markets. As such, their expected Sharpe ratio should be higher than that of the market.

    The strategies' distinct objectives mean they tend to fall into different allocation buckets within an investor's portfolio. Smart beta strategies behave like an equity investment and typically fall under the long-only, growth portion of a portfolio. Alternative beta strategies, in contrast, are largely uncorrelated to equities, so they are often viewed as an absolute-return strategy and a diversifier within a portfolio.

    Figure 1

    Correlation, beta and risk exposure to the S&P 500

    Calculated using weekly data, for a selection of Smart Beta funds. Risk exposure is calculated as the fraction of variance explained by the S&P 500. Analysis does not take into account distributions.

    StrategyStarting dateCorrelation

    to S&P 500

    Beta to

    S&P 500

    Portion of risk (variance) explained by the S&P 500
    iShares MSCI USA Momentum Factor ETFJan. 201291%0.9882%
    iShares MSCI USA Minimimum Volatility ETFJan. 201090%0.7281%
    Russell 1000 Growth IndexJan. 200096%1.0492%
    iShares MSCI USA Quality Factor ETFJan. 201298%0.9995%
    DoubleLine Shiller Enhanced CAPEJan. 201296%0.9792%
    iShares MSCI USA Size Factor ETFJan. 201289%0.8280%
    iShares Select Dividend ETFJan 200296%0.9193%
    iShares Core High Dividend ETFJan. 201086%0.6873%
    iShares Core Dividend Growth ETF Jan. 201397%0.9294%
    iShares MSCI USA Value Factor ETF Jan. 201392%1.0384%
    Russell 1000 Value IndexJan. 200096%0.9893%
    PIMCO RAE Fundamental PlusJan. 200482%1.1768%
    Average92%0.9386%
    Source: "3 Things to Know About Smart-Beta Funds," Wall Street Journal, October 4, 2015

    Implementation

    Smart and alternative beta strategies differ in their implementation.

    Generally speaking, smart beta strategies are constructed as long-only portfolios meant to provide exposure to equities by following indexes constructed by weighting that is different from those weighted by market cap. They buy stocks and avoid derivatives and other financial instruments with embedded leverage. Some of the more sophisticated smart beta strategies will attempt to neutralize sector biases that can be associated with certain market phenomena, such as the low volatility factor that tends to overweight utilities. Like traditional market capitalization indexes, smart beta strategies are often rebalanced based on a fixed, periodic basis, so in between rebalancing dates, exposures to market factors can vary.

    Alternative beta strategies are constructed as long/short portfolios to have minimal beta exposure to equities, meaning leverage is typically used to meet return and risk targets. As such, alternative beta strategies will not only buy stocks, but also derivatives and other financial instruments with embedded leverage. Implementing a long/short portfolio means shorting equities, which requires experience with prime brokerage agreements, margin requirements, financing costs, and an understanding of true levels of short interest and availability. Alternative beta strategies often have a higher turnover because they typically target a constant risk and often reassess both signals and risks daily, based on the market environment.

    Fees

    Smart beta strategies are ostensibly cheaper than alternative beta strategies. However, a comparison of fees without consideration for the desired outcome for each strategy is overly simplistic.

    Most of the risk and return for smart beta strategies comes from equity markets, in our example the S&P 500. The "active risk" component, that is, the risk from the smart beta component, is much smaller.

    Bear in mind, in today's marketplace of financial products, investors can source passive exposure to the market risk through low-cost index funds and exchange-traded funds for basis points. Figure 2 shows that, based on our previous sample of smart beta funds, 86% of the risk is explained by the market or S&P 500 and only 14% is explained by the active bet on certain factors. In contrast, nearly all of the risk for typical alternative beta strategies should be derived from non-market factors. Once the fees are normalized by the amount of risk from non-market factors, they appear to be more comparable for smart and alternative beta strategies.

    Conclusion

    Smart beta strategies seek to provide a higher Sharpe ratio than traditional, market-capitalization indexes. In contrast, alternative beta strategies are absolute-return strategies, historically used by hedge funds to provide diversification. Their different investment objectives and implementation requires a different skill set from the investment manager.

    Although smart beta strategies appear to be cheaper, investors would be wise to examine fees in the context of the risk exposure and return profile they are seeking. We would argue that when the fee is normalized by the amount of risk from the smart beta component, the costs of the two strategies are comparable.

    As institutions continue to invest in quantitative strategies and examine the merits of smart and alternative beta, it is our hope that investors will better understand the two strategies, what they aim to deliver, how they fit within a portfolio's construction, and, ultimately, make more informed investment decisions.

    Philippe Jordan is the New York-based president of Capital Fund Management. This article represents the views of the author. It was submitted and edited under Pensions & Investments guidelines, but is not a product of P&I's editorial team.

    Related Articles
    Managers turn to deconstructing alpha and beta
    Hedge fund investors apply core-satellite
    Be wary of unintended risk
    Low-cost demands spurring managed futures evolution
    Commentary: Wall Street analyst behavior – source of alpha
    Factor investing making up larger portion of asset owners' portfolios — survey
    Overdiversification taking a toll on performance
    Recommended for You
    Photo of FSSA Investment Management's Winston Ke
    Commentary: Invest in quality Chinese companies when people are bearish on China
    pi_20230925p10-murray_i.jpg
    Commentary: Understanding rising risk of ESG litigation for private markets
    Photo of the Ford Foundation's Roy Swan
    Commentary: How to approach endowment impact investing — a David Swensen-inspired strategy for social and financial returns
    Multiple Tailwinds Propel Private Credit
    Sponsored Content: Multiple Tailwinds Propel Private Credit
    Sponsored
    White Papers
    2023 Hot Topics in Retirement and Financial Wellbeing
    Bonds: Shaken, but Not Stirred
    A Study of Allocations to Alternative Investments by Institutions and Financial…
    Unlocking Hidden Value in Japan
    The Art of the Possible in Data Automation for Institutional Investors
    Parnassus View - Investing in AI: Transformative New Tech, Same Old Rules
    View More
    Sponsored Content
    Partner Content
    The Industrialization of ESG Investment
    For institutional investors, ETFs can make meeting liquidity needs easier
    Gold: the most effective commodity investment
    2021 Investment Outlook | Investing Beyond the Pandemic: A Reset for Portfolios
    Ten ways retirement plan professionals add value to plan sponsors
    Gold: an efficient hedge
    View More
    E-MAIL NEWSLETTERS

    Sign up and get the best of News delivered straight to your email inbox, free of charge. Choose your news – we will deliver.

    Subscribe Today
    December 12, 2022 page one

    Get access to the news, research and analysis of events affecting the retirement and institutional money management businesses from a worldwide network of reporters and editors.

    Subscribe
    Connect With Us
    • RSS
    • Twitter
    • Facebook
    • LinkedIn

    Our Mission

    To consistently deliver news, research and analysis to the executives who manage the flow of funds in the institutional investment market.

    About Us

    Main Office
    685 Third Avenue
    Tenth Floor
    New York, NY 10017-4036

    Chicago Office
    130 E. Randolph St.
    Suite 3200
    Chicago, IL 60601

    Contact Us

    Careers at Crain

    About Pensions & Investments

     

    Advertising
    • Media Kit
    • P&I Custom Content
    • P&I Careers | Post a Job
    • Reprints & Permissions
    Resources
    • Subscribe
    • Newsletters
    • FAQ
    • P&I Research Center
    • Site map
    • Staff Directory
    Legal
    • Privacy Policy
    • Terms and Conditions
    • Privacy Request
    Pensions & Investments
    Copyright © 1996-2023. Crain Communications, Inc. All Rights Reserved.
    • Topics
      • Alternatives
      • Artificial Intelligence
      • Consultants
      • Defined Contribution
      • ESG
      • ETFs
      • Face to Face
      • Hedge Funds
      • Industry Voices
      • Investing
      • Money Management
      • Partner Content
      • Pension Funds
      • Private Equity
      • Real Estate
      • Regulation
      • SECURE 2.0
      • Special Reports
      • Washington
      • White Papers
    • Rankings & Awards
      • 1,000 Largest Retirement Plans
      • Top-Performing Managers
      • Largest Money Managers
      • DC Money Managers
      • DC Record Keepers
      • Largest Hedge Fund Managers
      • World's Largest Retirement Funds
      • Best Places to Work in Money Management
      • Excellence & Innovation Awards
      • WPS Innovation Awards
      • Influential Women in Institutional Investing 2023
      • Eddy Awards
    • ETFs
      • Latest ETF News
      • Fund Screener
      • Education Center
      • Equities
      • Fixed Income
      • Commodities
      • Actively Managed
      • Alternatives
      • ESG Rated
    • ESG
      • Latest ESG News
      • The Institutional Investor’s Guide to ESG Investing
      • ESG Sustainability - Gaining Momentum
      • ESG Investing | Industry Brief
      • Innovation in ESG Investing
      • 2023 ESG Investing Conference
      • ESG Rated ETFs
      • Divestment Database
    • Defined Contribution
      • Latest DC News
      • The Plan Sponsor's Guide to Retirement Income
      • DC Money Manager Rankings
      • DC Record Keeper Rankings
      • Innovations in DC
      • DC Plan Design: Improving Participant Outcomes
      • 2023 Defined Contribution East Conference
    • Searches & Hires
      • Latest Searches & Hires News
      • Searches & Hires Database
      • RFPs
    • Research Center
      • The P&I Research Center
      • Earnings Tracker
      • Endowment Returns Tracker
      • Corporate Pension Contribution Tracker
      • Pension Fund Returns Tracker
      • Pension Risk Transfer Database
    • Careers
    • Events
      • View All Conferences
      • View All Webinars