Smart beta: Bridging the active/passive gap

Kathleen Gallagher

While the investment community has not stopped arguing the age-old active versus passive conundrum, we believe there is a simple solution to bridge the gap.

Smart beta exchange traded funds (ETFs) combine the low cost and discipline of passive management with active management’s potential for outperformance and thus are able to maximise risk-adjusted returns more efficiently.

Over the year to August 2023, $807 million has flowed into these strategies and trends show that this is only going to keep growing.

Despite the increasing interest, many advisers consider smart beta as a catchall for a variety of strategies and overlook the fact that the approaches within the category are differentiated and nuanced.

Factor investing at one stage was primarily the domain of active managers who used algorithms to analyse massive amounts of security data such as PE ratios, gearing levels, and yield to develop factor strategies.

Most smart beta approaches are focused on factors that drive risk and return. These factors include:

• Value – investing in listed companies exhibiting characteristics indicating it is undervalued relative to their fundamentals. These companies have the potential to appreciate in value when the market recognises its true value.
• Quality – investing in companies that are expected to do better in the long term versus other companies as they have delivered consistent levels of profitability, stable earnings, and lower debt-to-equity ratios.
• Minimum volatility – selecting companies exhibiting lower variability in returns compared to the broader market. The objective here is to reduce or manage the overall risk of a portfolio.

Single versus multi-factor

While there is long-term outperformance of these three factors, as documented by academic research, over the short-term the performance of single factors can be cyclical.

It is also difficult to time individual factors correctly as they can experience periods of underperformance relative to market cap weighted indices.

Given the uncorrelated performance of these three factors, combining them in one multi-factor, or core-oriented, strategy has several potential benefits.

Multi-factor approaches allow investors to diversify across factors and improve consistency in performance. This can help advisers navigate adverse markets conditions better.

The implementation of a diversified multi-factor exposure can therefore be used as a complement or a replacement for both active and passive core allocations.

For example, a smart beta ETF that combines value, quality and minimum volatility factors can provide an adviser with a cost-effective solution that creates a low-volatility strategy with an equal focus on high-quality and attractively valued firms.

This offers a potential for higher risk adjusted returns, typically at a lower cost relative to active strategies.

The bottom line

Smart beta indexing in effect combines the low cost and discipline of passive management with active management’s potential for outperformance.

The combination of attractive passive and active features through smart beta creates an opportunity for investors to rethink how they allocate within the core of their portfolios.

Additionally, having multiple factors in a single vehicle can reduce the amount of rebalancing for investors.

By Kathleen Gallagher, Head of SPDR ETFs Australia and Head of Model Portfolios EMEA & APAC

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Important Disclosure: Issued by State Street Global Advisors, Australia Services Limited (AFSL Number 274900, ABN 16 108 671 441). You should seek professional advice and consider the product disclosure statement and target market determination, available at www.ssga.com/au, before deciding whether to acquire or continue to hold units in an ETF.  This material is general information only and does not take into account your individual objectives, financial situation or needs and you should consider whether it is appropriate for you. This material should not be considered a solicitation to buy or sell a security. Investing involves risk including the risk of loss of principal. Diversification does not ensure a profit or guarantee against loss. Frequent trading of ETFs could significantly increase commissions and other costs such that they may offset any savings from low fees or costs.