Smart Beta investment strategies are one of the fastest-growing areas of the market. OppenheimerFunds believes Smart Beta can have the potential for better portfolio outcomes including enhanced returns, reduced risks and improved diversification.

Traditional market-cap weighted index funds have a long history and a place in many portfolios, but may be subject to limitations as investors look for more outcome-oriented approaches. To learn more about how investors can potentially benefit over the long run with Smart Beta, we spoke with Mo Haghbin, Head of Product, Beta Solutions; and David Mazza, Head of the Beta Solutions ETF Specialist and Investment Marketing teams in the latest episode of the OppenheimerFunds World Financial Podcast .

Here are some highlights from our conversation.

Brian Levitt: What is Smart Beta? Where did it come from and why is it all the rage all of a sudden?

Mo Haghbin: Smart Beta really is, in my view, more of a marketing term than an investment term. As beta strategies have evolved over time, people are looking for other ways to get beta exposures efficiently, so factor-based investing is, by most people’s views, the start of Smart Beta investing. It’s kind of the philosophical underpinnings of Smart Beta.

David Mazza: Smart Beta is the marketing term for really anything that is a beta-type product, an index-type product that is not weighted by market capitalization. When we think about what it’s doing, it’s looking to harness a factor, and really, these are style factors. I think everybody knows the Morningstar Style Box. We have large value, large blend, large growth – and down. Mid and small. But when we start moving into other types of premias, that’s really what we’re talking about here.

Style boxes make sense … but there are other elements that drive returns systematically through time. If we take a step back; just think about the macroeconomic environment. There are drivers that just exist. There’s an equity risk premium, meaning you should be compensated by taking on the risks of an equity above a bond.

Levitt: And equities outperform bonds something like 85% of the time.1

Mazza: Exactly – so that’s something that’s a well-known concept. We’ve accepted that. There are things in the fixed income markets that drive returns, right, like inflation or credit risk if we’re talking about a credit instrument vs. a Treasury. If we focus just on the stock market, the same thing can be said, meaning over the long run. Now, performance may be cyclical, but factors like value work. Factors like momentum work. There are other factors, like low volatility, high dividend yield, that actually work as well. What you can do is, take a look at those premias that come with investing in a factor framework and then construct portfolios accordingly.

Levitt: Let’s talk about value. Over the last eight years, we’ve been in a persistent, prolonged growth market. Is that a statistical or historical anomaly? Or is the value factor going away?

Haghbin: What Dave said really is an important thing to recognize – these things are supposed to be long-term premias, so at any point in time they can underperform market cap – or they can underperform the traditional beta products. I would argue that value is not dead. We just happen to be in a growth market. And similarly for momentum – momentum will go in and out of favor.

Levitt: Low volatility has the most incredible back test we’ve ever seen, and yet had a selloff in 2016. How should we look at back tests in general?

Haghbin: We joke about this all the time – we’ve never seen back tests that you don’t like. They’re engineered to be good. What I think we need to be mindful of is there’s probably a little more data mining in some of these strategies than we’d like to admit. There’s been a lot of research that shows that once you’ve taken into account frictions and implantation costs – some of these things we believe to be premias actually aren’t. They don’t actually have significant alpha.

Low volatility does have an economic rationale. There is a theory behind why low volatility should over long periods of time outperform. One is the behavioral side. The other is leverage. Return expectations have come down – I’d love to get 10% equity return over the next 30 years, but most people would argue those times are gone.

In order for people to hit their targets in terms of retirement, they have to take more risks. Therefore there are parts of the market that are under-loved and underappreciated. That if you hold a portfolio of stocks that have lower volatility, over long periods of time, you’ll capture that premia.

Levitt: Is it possible to combine factors? And if so, is there a way to set rules up to do so systematically? Where’s the next frontier – multifactor, fixed income?

Mazza: Some of the exciting work we’re doing at OppenheimerFunds is looking at how we could combine these factors together to lead to particular outcomes for an investor. Reason being, because of the cyclicality that factors have, maybe if we combine all of these elements together we can meet an outcome for a client that’s a bit different and less subject to the potential for – in some markets you’re really outperforming while in other markets you have the potential for underperformance.

Haghbin: We’ve found through research that some of these factors will outperform in certain periods. For example, momentum tends to outperform when you’re in an upward trending market. Low volatility and quality tend to outperform when you’re in recession or slowdown. They’re more defensive in nature.

When we uncover these things through the research, one way of building new products is bringing them together. And just like diversification is important in a stock portfolio, diversification is important in a factor portfolio. So we can combine in a way that full cycle, produces a result that’s a little more compelling. It’s more all-weather, so you don’t see that 800 basis point drawdown in one year.

Levitt: Mo, as the Head of Product Development, what excites you most about the Smart Beta space and where do you think we’re headed as an industry over the next few years?

Haghbin: The area that we’re focused on, in terms of research – the equity side as well as the fixed income side. It’s new and novel and we’re really just starting to crack the egg here. Traditional beta, as well as it’s done and the purpose it serves, I think everyone would agree belongs in the portfolio. Smart Beta is something where there hasn’t necessarily been as much product innovation and there’s an opportunity for us not only to do good work on the equity side, but also extend that work in fixed income and other asset classes. Even combining in a multi-asset portfolio, so what really excites me is just the opportunity to work on some of these new, innovative solutions for our clients.

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1Source: T.Rowe Price