With the growth of food-focused television and social media content, food trends have gone mainstream. Consider the cronut, a pastry invented in 2013 by New York City chef Dominique Ansel, that combines the flakiness of a croissant with the look and feel of a donut. It's fried! The cronut quickly caused a sensation in the city, with locals and tourists enduring hours-long lines to obtain one. The pastry's success inspired numerous imitations from bakeries large and small but, as time passed, its popularity waned and new fads emerged (See: avocado toast). Compared with a pastry classic, such as the cookie, the cronut was a flash in the proverbial (cake) pan.

Let's pivot from cronuts to smart beta, otherwise known as factor investing. Some investors have tired of hearing about smart beta, and liken it to a short-term fad, not unlike the cronut. Yet, while industry marketers have glorified the term, smart beta strategies continue to grow in popularity because, compared with market-capitalization-weighted strategies, they allow investors to exert more control over their portfolio outcomes in the face of an increasingly challenging investment environment. Smart beta may feel like a fad to some, but we would argue that this approach is on track to join active and passive management as part of the investing establishment.

What Is Smart Beta?

Smart beta, otherwise known as factor investing, is a low-cost, rules-based approach that can provide investors with the potential for improved returns, lower risk, and increased diversification as compared with a traditional passive approach. In its simplest form, smart beta sits at the intersection of active and passive management and offers some benefits from both ends of the spectrum. Exhibit 1.  Like active management, smart beta strategies may add excess returns beyond passive, market-capitalization-based strategies and may also reduce portfolio risk through active security selection. Like traditional passive investing, smart beta is low cost, has a fully transparent investment process, and provides tax efficiency.

Exhibit 1: Smart Beta Resides at the Intersection of Active and Traditional Passive Management -- OppenheimerFunds

Smart Beta Is Not New

While smart beta may seem new, it got its start several decades ago and is supported by extensive academic and practitioner research, generally focused on factor-based index investing. Exhibit 2. Factors may also have a hand in the success of many active strategies, as research has shown that significant portions of returns derived from actively managed strategies can be explained by exposure to certain factors.

Exhibit 2: Key Milestones in the Evolution of Smart Beta -- OppenheimerFunds

A New Way to Think About Alpha

Before the rise of smart beta, the investment industry relied on a simple interpretation of the alpha-beta relationship, with alpha defined as any return not attributable to beta exposure. Today, as smart beta has evolved, a more nuanced interpretation of alpha has emerged that attributes a portion of alpha to factor betas, such as value, momentum, size and quality. Exhibit 3.

Exhibit 3: Alpha Not Includes Factor Beta -- OppenheimerFunds

The industry is now evolving toward a bifurcation of active management into smart beta (or factor beta exposure) and pure alpha (or active management). In other words, as smart beta strategies have moved into the mainstream, investors have increased their awareness of where portfolio returns are coming from, how to decompose portfolios into those return sources, and whether they are being compensated for taking on those exposures. So where does this leave traditional active management? We believe that the recognition that pure alpha makes up a smaller portion of a portfolio’s aggregate return underscores the value offered by truly skilled active managers who can deliver it consistently.

Types of Smart Beta Strategies

In our view, there are three main categories of smart beta strategies—Alternatively Weighted, Single-Factor and Multi-Factor.

1. Alternatively Weighted

In seeking to achieve specific objectives, alternatively weighted strategies decouple a security’s weighting in the portfolio from its price in favor of a different weighting scheme.  In contrast to a single-factor or multi-factor approach, alternatively weighted strategies do not isolate a factor through a scoring process or optimization. In other words, factor exposures from alternatively weighted strategies are a beneficial output, not a targeted input. For example, if you weight a portfolio by a company fundamental, such as revenue, rather than market capitalization, it generally orients the portfolio toward value.

2. Single-Factor

Single-factor strategies deliver exposure to specific style factors, such as value, quality or momentum, to exploit the power that these variables can offer. These strategies can be created using a rules-based approach or a more sophisticated optimization procedure.  

3. Multi-Factor

Multi-factor strategies combine two or more factors to construct portfolios that will meet specific objectives. The goal is to develop a strategy with the potential to be a better core holding for investors than any single-factor approach could be. In addition, since many single-factor strategies have low to negative correlations with each other, the factors can be combined in ways that capitalize on the power of diversification to meet a specific outcome.

The Takeaway

Because smart beta portfolios leverage the power of factor investing, they enable investors to combine the best aspects of active and passive investing. While we cannot predict the fate of cronuts, we believe that smart beta has the staying power of the classic cookie, and will be embraced by investors for decades. If you haven’t embraced either, I recommend you give them both a taste.

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