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Weekly Comment - Week 49, 2014The term ‘Smart Beta’ is being heard more and more in investment discussions these days. It’s not clear, however, what this actually means. One famous financial economist – Bill Sharpe (the winner of the Nobel prize for his work on the Capital Asset Pricing Model, or CAPM) – actually called it a complete misnomer. As he pointed out, “What can be smart about Beta? It is what it is – the market – isn’t it?” From our perspective we believe it is a meaningful term – albeit a potentially confusing one. To us there are two versions of ‘smart beta’. They differ in what they do, but are similar in their non-discretionary (or systematic) nature.

Firstly, there is the version which attempts to be ‘smart’ about having beta exposure. These funds or portfolios attempt to use systematic rules to decide when to be ‘in the market’ i.e. to own beta (however defined) and when not to own it i.e. to be in cash. At MitonOptimal we have two versions of this approach. Within our Commodities Boutique we are working on a ‘Smart MOCCI’ or smarter version of the proprietary MitonOptimal Commodities Consumption Index (the MOCCI). This index was developed to provide a large institutional investor with an inflation hedge by providing exposure to a portfolio of commodities that is matched to their client’s consumption of these commodities (more importantly food and energy commodities). The problem with this ‘beta’ product is that while it provides enhanced inflation hedging capabilities when commodity prices are going up. But it doesn’t protect the investors from experiencing losses when these same prices are coming down (which they often do). While these losses should be seen as acceptable (because inflation is also coming down), our experience is that this is not the case, all investors hate losses! As a result we have developed a ‘smart’ version of the index, which is designed to give investors exposure to the index constituents when their prices are going up, but to be invested in cash when they are coming down. The other example is our Defended Equity Fund, which is being launched shortly. Which will be run on a similar basis, but on the equity market. Investors will be invested in the equity market (beta) when the systematic model used suggests it is trending up and in cash when it is trending down. As these two examples show, the approach can be used in effectively any investment context.

The second example of the ‘Smart Beta’ concept is the use of non-market capitalisation (“cap”) weights when creating (or copying) an alternative ‘smart’ index. All standard market indices (e.g. the JSE All Share Index) use market cap weights while the new, alternative indices use something else. The first examples of these used fundamental factors such as profit, sales, dividends or some combination of these factors. Others include equal weights or (low) volatility. More recently, index providers (and their partners – index tracker fund providers) have been focussing on risk factor metrics, such as value, momentum and (low) volatility. These are anomalies (in the context of the efficient market hypothesis) which academic research shows have earned a risk premium. In other words, you can outperform the market (as measured by the traditional market cap weighted beta) if you are consistently invested in a portfolio of assets that reflect them (e.g. value or momentum stocks).

In short you can be ‘smart’ about beta by either trying to be in the market at the right time, or by defining the market differently in a way that earns a premium over time. The challenge for investors with the first approach is: do the rules governing the timing of market exposure actually work? For the second approach, the challenge is: how robust are the returns to these strategies? Are they real in that they continue into the future or are they simply a result of data mining?

‘Smart Beta’ is a very exciting development in the investment universe and provides very real style diversification benefits to traditional discretionary (or active) managers, much in the same way that you get good and bad active managers. However, you are going to get good and bad ‘Smart Beta’ products. Our job is to find out which is which!

Weekly comment Week 48 2014 - Smart Beta - EG.pdf


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MitonOptimal International Limited is registered in Guernsey (Registration No. 51561) and is the overlying holding company of the companies that make up the MitonOptimal Group.
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