An all-inclusive descriptor of systematic, non-market-cap investing, smart beta has witnessed tremendous growth in demand, and assets under management in related exchange-traded products have soared to USD 429 billion globally.1 Product launches have correspondingly been ramped up; they now number in the hundreds. Yet, despite this diversity in the types of strategies available, the vast majority aim to reap excess risk-adjusted return by targeting a limited set of risk factors—with value, momentum, volatility, dividend yield, size, and quality among the best recognized and empirically supported. It is therefore important to appreciate the underlying drivers of risk and return for these diverse strategies and draw distinctions between them, especially for those that share homogeneous objectives, as in the case of low volatility and minimum-variance strategies.
Many of the dissimilarities are rooted in differences in portfolio construction, the effects of which can be challenging to decipher, even when the mathematical properties inherent in them are well understood. The difficulty may be further compounded by market participants’ inclination to judge strategies based on the strength of ex-post risk-adjusted performance; while that tendency can help inform the decision-making process, it has potential limitations. For one, there is a dearth of live performance, and a large portion of the advertised ex-post returns for these strategies include back-tested simulations, which may not be repeated once the strategies are launched. Factor performance can also vary immenselyover short periods of time, and achieving an inferior risk-adjusted performance does not automatically signify that the strategy is ineffectual in harvesting the factor in question. By the same token, attaining a superior ex-post return does not necessarily translate into the strategy’s effectiveness, because the return may come from factors other than the ones being aimed for. For this reason, it may be better to evaluate smart beta strategies against their capacity to provide high, persistent exposures to the selected factor and view them from both a risk and return perspective.