If you have been investing your money, you might have heard of beta. Beta is a measure of the volatility of a stock compared to the entire market. To a lesser extent, you might have heard of alpha, i.e. excess return you gained against a market index. But have you heard of smart beta? In recent years, smart beta investing has been revolutionising the investment market. Today, smart beta investing has become a mainstream investment strategy.
So, what exactly is smart beta investing? And more importantly, why does it matter to you?
What is smart beta investing?
According to Investopedia, smart beta investing is the best of passive investing and active investing strategies combined into one. Instead of using conventional market capitalisation as weightage for stocks in an index, smart beta investing uses an alternate weighting scheme. This could be based on a multitude of factors like volatility, momentum, quality, value, size and dividends. Each smart beta investing strategy is unique in terms of the indexes, biases and factors that go into deciding the portfolio constitution.
In other words, smart beta investing is an index-based investment strategy that seeks to generate superior risk-adjusted returns through transparent quantitative techniques and rules-based criteria.
How did smart beta investing come about?
The term ‘smart beta investing’ was first coined by consulting firm Towers Watson in the early 2000s. Despite its seemingly modern name, smart beta investing isn’t entirely new. Its roots stretch back several decades. Smart beta investing builds on several market theories such as CAPM, Efficient Market Hypothesis and Modern Portfolio Theory to create basic rules-based investing strategies, aka smart beta strategies.
What differentiates smart beta investing?
Each smart beta investing strategy consists of four main components. These four components are what makes smart beta investing special.
1. Base: Index investing
Index investing forms the base of every smart beta investment strategy. Like the construction of indices, the smart beta investing strategy will invest in every stock component of an index. However, instead of utilizing the traditional market-cap weighting, the weighting is factor-based. There are multiple factors that can be used to determine the weighting. The most common factors used to determine the weight are volatility, momentum, quality, value, size, and dividends.
2. Aims to generate a superior risk-adjusted return
Beta investing refers to index investing where you invest in the market index. Smart beta investing, on the other hand, tries to be ‘smarter’ by aiming to generate superior risk-adjusted return when the opportunity is ripe. Generating superior risk-adjusted return works in three ways. It either seeks to outperform typical market cap-weighted benchmark index, mitigate portfolio risk or both through smarter allocation of capital.
3. Quantitative techniques
Smart beta investing relies heavily on quantitative techniques and rule-based criteria to achieve superior risk-adjusted return. For instance, smart beta investing leverages on CAPM theory to ensure that it takes on the lowest risk to achieve the desired investment return, i.e. mean-variance efficient.
4. Factor-based investing
Following years of extensive research, researchers have identified specific factors that are primary drivers of investment return. These factors are Volatility, Momentum, Quality, Size, Value, and Dividend.
Inexpensive stocks have shown to be able to generate above average returns compared to stocks that are trading at a higher valuation. Smart beta investing strategies that use value as one of its factors will use PE and PB ratio to identify cheap stocks.
Another factor that influences investment return is momentum. Momentum refers to the recent performance of the stock, e.g. investment return over the last 3 months. Stocks with stronger momentum have shown the tendency to generate higher investment returns than low momentum stocks. Thus, smart beta investing will seek to increase the weightage on strong momentum stocks.
Size effect is a pretty well-known factor within the finance community. The size effect theorizes that companies with smaller market capitalization tend to outperform larger cap companies. Thus, unlike traditional market-cap weighted indices that give more weightage to large-cap companies, smart beta investing places more emphasis on small-cap companies.
Volatility is a lesser used factor when it comes to investing, especially among newer investors. However, smart beta investing leverages on volatility to get an edge against other investment strategies. Stocks that displayed low volatility have earned higher risk-adjusted returns than stocks with high volatility. So, if a stock has a low volatility, there is a likelihood of the stock being given a higher weightage in the smart beta portfolio.
It is not uncommon to use dividend yield as a screening criterion. But unlike usual investing strategies, smart beta investing takes dividend yield as a key consideration factor rather than a good-to-have factor. Based on historical data, stocks with higher dividend yield have produced greater investment returns than stocks with low dividend yields. Thus, smart beta investing will give more weightage towards stocks with higher dividend yield.
Apart from these 5 factors, there are also other factors like Quality, Buyback and Growth that are widely used in smart beta investment strategies. Smart beta investment strategies can solely focus on one of the factors, a combination of some or all of them. It depends on the smart beta portfolio that you are investing in.
Read also: Beginner’s Guide To Investing Strategies
Smart beta vs passive vs active investing
To put the comparison between smart beta, passive investing and active investing into perspective, here is a summary of their key differences.
|Rule-based||Yes (Traditional market cap rule)||Yes||No|
|Outperformance potential||Nil||Medium||Medium to High|
|Liquidity||High||Medium to High||Low to High|
|Investment Capacity||High||High||Low to High|
|Portfolio Turnover||Low||Low||Medium to High|
|Fees & Costs||Low||Low to Medium||High|
Why you should know about smart beta investing
Smart beta investing has shown a good track record of outperformance
According to a long-term study, smart beta investing is showing good performance relative to the S&P 500. The study was done by asset manager Invesco which studied the performance of 5 factors (e.g. quality, momentum, volatility) and 5 alternative weightings from 1992 to 2015. The results showed that all 5 of the factors and alternative weighting methodologies beat the absolute returns of S&P 500 index. Majority of the smart beta investing strategies in the study also delivered higher risk-adjusted returns than the S&P 500 index.
Smart beta investing = Active investing at a low cost, higher transparency
To put it simply, a smart beta investment strategy is almost like an active investment strategy. While providing comparable investment returns, smart beta investing achieves it at a lower cost and much higher transparency. You can easily find out the constituent components of a smart beta investment portfolio. This is unlike an actively managed portfolio where the components and why they were added into the portfolio are not known.
Smart beta investing adjusts according to market condition
With smart beta investing, investors do not have to worry about the current market condition. While you might have lingering concerns over the changing state of the economy and the impact on your investments, these are taken care of by smart beta investing. Smart beta investing is designed to tackle different macroeconomic environments using a combination of single factor strategies.
Where can you find smart beta investment opportunities?
The best way to invest in a smart beta investment strategy is to do it through an exchange-traded fund (ETF). There are two types of smart beta investing ETFs that are available to Singapore-based investors: Lion-Phillip S-REIT ETF and the recently launched Phillip SING Income ETF.
Lion-Phillip S-REIT ETF
Lion-Phillip S-REIT ETF is a smart beta ETF that is jointly launched by Lion Global Investors and Philip Capital Management. The ETF was designed to appeal to investors who are looking to participate in the growth story of Singapore’s REITs in a low cost and transparent manner. It is one of the first ETFs in the world to focus solely on Singapore-listed REITs.
The objective of Lion-Phillip S-REIT ETF is to replicate and beat the performance of the Morningstar® Singapore REIT Yield Focus Index℠. The Index is compiled and calculated by Morningstar Research. It was designed to screen for high-yielding REITs with superior quality and financial health. S-REITs are selected into the portfolio based on 3 core proprietary factors: Quality, financial health and dividend yield.
3 proprietary factors: Quality, financial health and dividend yield
To determine the business quality, Morningstar looks at the REIT’s economic moat, i.e. its sustainable competitive advantage that allows the REIT to protect its long-term profits and market share from competitors. Morningstar then uses an algorithm to determine the Quantitative Moat Rating to predict the Economic Moat Rating. A positive score implies that the company has high business quality.
2. Financial health
The financial health of an S-REIT is determined by the distance to default criterion. An equation is used to calculate the probability the REIT will go bankrupt. The score is then compared to the score of a peer group of stocks within the REIT sector of developed Asia Pacific markets. The higher the score, the stronger the financial health of the company.
3. Dividend yield
The third factor that Morningstar considers when deciding which REIT to pick and how much weight to allocate to it is the dividend yield. Morningstar gives a higher rating when the trailing twelve months dividend yield is higher.
Current holdings of Lion-Phillip S-REIT ETF
Phillip SING Income ETF
Phillip SING Income ETF is a smart beta ETF that focuses on 30 high-quality stocks listed on the Singapore market. The Phillip SING Income ETF tracks the Morningstar® Singapore Yield Focus IndexSM and uses a series of factors to select the 30 stocks for inclusion into the index. The aim of the smart beta ETF is to deliver quality income to investors. According to Phillip Securities, it offers investors a cost-effective and diversified exposure to the Singapore market.
Phillip SING Income ETF uses 3 factors as well for its stock selection: Business quality, financial health and dividend yield. Firstly, Phillip SING Income ETF screens for companies with sustainable competitive advantage to protect income stream from erosion. Secondly, the financial health factor helps investors avoid companies with deteriorating balance sheets at risk of financial distress. Thirdly, it uses dividend yield to maximise return and anchors the portfolio in the most liquid and stable companies. Dividend yield is also used as a factor to cap individual stock’s weight as a risk control.
Clueless about where to start? Check out our Beginner’s Guide: When Should You Start Investing and What to Do First