Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 143

Smart beta: watch the details

New index-based strategies known as ‘smart beta’ appear to be growing in popularity, but not all these strategies are created equal and investors should be mindful of implementation. These indices seek to outperform conventional market cap-weighted indices by breaking the link between a stock's desired weight and its market cap, instead deriving desired weights from characteristics such as book value, earnings or recent performance.

While many names are used for this approach, smart beta is the most common. The chart below shows assets managed under the smart beta label have grown to more than $US500 billion over the last 15 years. While still a small percentage of the overall market, this growth implies they are becoming a more popular choice. But are they the right choice?

Data show smart beta indices can provide exposure (sometimes inadvertently) to size, value and profitability premiums, but they may do so inefficiently and may subject investors to unnecessary risks. Also, there is no compelling evidence that aggregate long-term demand at the security level has changed because of inflows to smart beta strategies.

Without such evidence, it’s not possible to say that there is ‘more money chasing value’ today than in the past. Instead, flows into these indices may represent a transfer of assets from managers who target a similar set of securities using a more traditional active approach.

Identifying differences in expected return

Just as it is reasonable to expect equities to have higher expected returns than bonds, it is reasonable to expect different securities to have different expected returns. Different stocks can provide different hedging needs and risks. This may be investor-dependent if some investors are the natural holders of certain risks and others are not. Alternatively, in behavioural finance, tastes and preferences drive expected returns without associated ‘real’ risks or hedging preferences. Under either framework, there is a very low possibility of all stocks having the same expected return.

To identify information that can be used to determine differences in expected returns between securities, it is useful to begin with the valuation equation which links expectations about a firm's future profits to its current price through a discount rate. A low relative price is one indication that the market has discounted a company's expected future profits more heavily. Applying the same valuation logic, companies with similar price characteristics but different levels of expected profitability should have different expected returns.

What happens if everyone becomes a value investor? The answer is that it isn’t possible. Collectively, all investors must hold the entire equity market. For every investor who wants to overweight stocks with low relative price, there have to be investors who want to overweight stocks with high relative price.

As long as market participants apply different discount rates to different stocks, a strategy that uses a combination of current market prices and up-to-date firm characteristics can identify those differences today, tomorrow and into the future. Using current prices is the key to identifying these differences in discount rates.

The risk from ignoring prices

While we expect positive size, value and profitability premiums, not all strategies that pursue those premiums are created equal. Investors always have the option to invest in a plain vanilla broad market index fund. This is a decent option as these funds are transparent, low cost, low turnover and well diversified. The success of conventional market cap-weighted indices can be explained in part because they have delivered what they set out to deliver - market rates of return.

However, it is not clear whether smart beta indices will be able to deliver their goal of outperforming the market. Unfortunately, good back-tested research does not provide enough information to make this assessment. The implementation details matter.

For example, if a smart beta index ignores market prices, it is difficult to infer if it will have a higher expected return than the market going forward. In back-tested research, the index may have provided inadvertent exposure to stocks with low relative prices and high profitability, and outperformed the market. If current market prices are ignored in index construction, this implies the index is not directly managing that exposure and may not outperform in the future.

A smart beta index also may generate excessive short-term demand for less liquid stocks and create unnecessary turnover. As the assets attached to that index increase, there may be a drag on returns due to an index reconstitution effect.

So when evaluating a strategy, there are a number of questions to consider, including:

  • Does the strategy use current prices when choosing securities? If a strategy ignores current prices, a vital component of what drives differences in expected returns is omitted.
  • Is there unnecessary turnover? Security weights that are not tied to market cap weights may incur excessive turnover that increases implementation costs without increasing expected returns relative to a market cap-based approach.
  • How is the strategy rebalanced? Trading that demands immediacy from the market can be costly, even if turnover is low.
  • Are there avoidable risks and is the portfolio well-diversified given its mandate? Investors should be cautious about an approach that allows for extreme positions in a few securities. While this can yield good back-tested results, it can also result in significant company-specific risk.

An alternative solution

A better approach is to begin with research into how markets work. A sensible story can boost one's confidence that a premium is positive in theory, while a low-cost approach improves the chances of capturing premiums in practice. No premium is a sure thing. Costs, on the other hand, surely lower investors' net returns. Investors should consider whether a strategy would be a good investment even if the premiums are smaller in the future or do not appear at all.

It’s important to have a solution that will be at least as good as the market portfolio in most scenarios, including if the premiums do not show up. A strategy with high implementation costs will have lower expected returns than the market portfolio if the targeted premiums do not exceed the costs. Keeping opportunity costs low helps a strategy maintain market-like expected returns even if premiums do not appear in the future.

A well-designed strategy that seeks to capture size, value and profitability premiums should minimise its opportunity cost relative to a broad market index. Key tools for doing that include using current prices in every part of the investment process and remaining well-diversified. As well, one should pursue premiums that lead to low strategy turnover and that eliminate unnecessary turnover. The final key is adopting a flexible approach to portfolio management and trading that balances competing premiums and considers explicit and implicit trading costs.

 

Marlena Lee is a Vice President, Research, and Gerard O’Reilly is Co-Chief Investment Officer and Head of Research with Dimensional Fund Advisors, an institutional asset manager with about $500 billion under management globally. This article is general educational material and does not consider the investment needs of any individual.

 


 

Leave a Comment:

RELATED ARTICLES

Why equal weighting resolves Australian index skews

The biggest rort of all

The potential of smart beta

banner

Most viewed in recent weeks

Which generation had it toughest?

Each generation believes its economic challenges were uniquely tough - but what does the data say? A closer look reveals a more nuanced, complex story behind the generational hardship debate. 

Maybe it’s time to consider taxing the family home

Australia could unlock smarter investment and greater equity by reforming housing tax concessions. Rethinking exemptions on the family home could benefit most Australians, especially renters and owners of modest homes.

The best way to get rich and retire early

This goes through the different options including shares, property and business ownership and declares a winner, as well as outlining the mindset needed to earn enough to never have to work again.

A perfect storm for housing affordability in Australia

Everyone has a theory as to why housing in Australia is so expensive. There are a lot of different factors at play, from skewed migration patterns to banking trends and housing's status as a national obsession.

Supercharging the ‘4% rule’ to ensure a richer retirement

The creator of the 4% rule for retirement withdrawals, Bill Bengen, has written a new book outlining fresh strategies to outlive your money, including holding fewer stocks in early retirement before increasing allocations.

Chinese steel - building a Sydney Harbour Bridge every 10 minutes

China's steel production, equivalent to building one Sydney Harbour Bridge every 10 minutes, has driven Australia's economic growth. With China's slowdown, what does this mean for Australia's economy and investments?

Latest Updates

Superannuation

Super crosses the retirement Rubicon

Australia's superannuation system faces a 'Rubicon' moment, a turning point where the focus is shifting from accumulation phase to retirement readiness, but unfortunately, many funds are not rising to the challenge.

Economy

Should Australia follow Trump's new brand of capitalism?

A new brand of capitalism may be emerging - one where governments take equity in private companies. Is it state overreach, or a smarter way to fund public goods without raising taxes?

Gold

Why gold may keep rising - and what could stop it

Central banks are buying, Asia’s investing, and gold’s going digital. The World Gold Council CEO reveals the structural shifts transforming the gold market - and the one economic wildcard that could change everything. 

Investment strategies

Fact, fiction and fission: The future of nuclear energy

Nuclear power is back in the spotlight, including in Australia. For investors exploring the sector, here are four key factors to consider in this evolving energy landscape. 

Taxation

The myth of Australia’s high corporate tax rate

Australia’s corporate tax rate is widely seen as a growth-killing burden. But for most local investors, it’s a mirage - erased by dividend imputation. So why is it still shaping national policy? 

Taxation

Should we change the company tax rate?

The headline 30% corporate tax rate masks a complex system of dividend imputation and franking credits that ensures Australian shareholders are taxed only once, challenging traditional measures of tax competitiveness. 

Investing

Noise cancelling for investors

A lot of the information at an investor's fingertips today has little long-term value. The modern investing greats are not united by access to faster information, but by their ability to filter out what doesn’t matter.

Sponsors

Alliances

© 2025 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.