Blog: Smart Beta - where active and passive meet

Lloyd Davies, is a financial adviser at Aberdeen-based Central Investment

Interest in smart beta indices has been fuelled by the global financial crisis, meaning that alternative methods of investing, which focus on controlling risk rather than simply maximising returns, have become a favourable choice for many investors.

Tools like smart-beta are being presented to help investors build well-diversified, multi-asset portfolios, bringing about unique performance characteristics that differ from the wider market of the past.

Smart Beta

Smart beta seeks to improve returns, reduce risks and enhance diversification for investors by providing exposure to the key investment factors of risk and return.

According to the Financial Times, smart beta strategies attempt to deliver a better risk and return trade-off than conventional market cap weighted indices by using alternative weighing schemes based on measures such as volatility or dividends.

Smart beta is not simply a fund or strategy, it’s an alternative way of thinking about investing beyond traditional active and passive management.

Passive Investing

A passive equity fund aims to replicate the performance of a cap-weighted index. A cap weighted index is one where the weight, meaning the proportion of each stock in the index, is determined by its market capitalisation, in other words how much the company is worth in terms of its shares.

Passive investing is a low cost strategy because changes in the security prices will adjust the weight automatically, meaning it requires little intervention and a relatively small number of trades.

Active Investing

Share prices are often volatile, unstable and subject to the circumstances of investors rather than necessarily representing the company’s true value based upon its assets, or its future expected return.

Active fund managers look at individual companies in detail and examine the differences between market capitalisation, what the market thinks they are worth now, and the actual and future value. Through this analysis, they build a portfolio using a particular selection of shares from an index and in a proportion that overall aims to outperform the relevant cap-weighted index.

This requires a number of analysts employed to investigate and monitor potentially interesting companies and comes at a higher cost than passive investing. However, unlike passive investing, an active fund has the potential to outperform the index.

So, where does smart beta fit into an investor’s portfolio?

Realistically, investors should analyse smart beta strategies in the same way they evaluate actively managed strategies. Getting the best out of investments means balancing a number of key factors: risk and rewards, spread of asset allocation, your personal preferences, previous investment experience and attitude to risk.

Combining features of both passive and active investing creates a diverse portfolio, and while smart beta allows investors to maintain many benefits of passive strategies while seeking improved returns or reduced risk, this strategy is not always right. Adapting to the current market and environment can add the same value which can be seen in active strategies or active funds managers.

At Central Investment we believe it is important not to be drawn to one specific strategy. Instead, have a specific purpose in mind and choose from among those that will act to fulfil it. Over time, investors learn what works best and what doesn’t – and that’s a smart way to stay ahead of the game.

www.centralinvestment.co.uk