Smart Beta vs Factors in Portfolio Construction

Smart Beta Might Not Be So Smart for Portfolios

August 2017. Reading Time: 10 Minutes. Author: Nicolas Rabener.

SUMMARY

  • Investors seek smart beta products for risk reduction
  • However, smart beta products are effectively long-only products with full equity risk
  • Only factor products, i.e. long-short portfolios, offer true diversification benefits and downside protection

INTRODUCTION

FTSE Russell’s 2017 Smart Beta Investor Survey showed that the Nr 1 objective for evaluating smart beta strategies was for risk reduction, followed by return enhancement. Naturally there are many types of smart beta strategies available to investors today, however, they are nearly all long-only products. If equity markets crash, then smart beta products will also crash and would not substantially reduce portfolio risks, i.e. fail the investment objective. In this short research note we will compare the difference between investing in smart beta versus factor products for an equity-centric portfolio (read Smart Beta vs Factor Returns).

METHODOLOGY

We’re going to focus on the S&P 500 and just two factors: Value and Growth. Given that these factors don’t tend to correlate, there should be some diversification benefits for the portfolio. In terms of smart beta we have chosen two products from Blackrock: IVE, the iShares S&P 500 Value ETF, and IVW, the iShares S&P 500 Growth ETF. Both of these have +$10bn AUM and a trading history of almost 20 years.

We calculate the factor performance for Value and Growth by creating long-short portfolios comprised of the top and bottom 30% of the US stock universe. The portfolios are constructed dollar-neutral and include 10bps of transaction costs (read Factor Construction: Beta vs $-Neutrality).

SMART BETA & FACTORS VS THE S&P 500

Before we move to portfolio construction, it’s worth familiarizing ourselves with the return profiles of the smart beta ETFs and factors. The chart below shows the performance of the smart beta ETFs for Value & Growth and the S&P 500. We can see that Value outperformed the S&