Investors should think of 'smart beta' as a portfolio management tool rather than a way to chase higher returns, says Vanguard.
Vanguard has released a new whitepaper titled Equity factor-based investing: A practitioner’s guide that says the term 'smart beta' is something of a misnomer.
"These products seek to achieve alpha, or outperformance of the market, through rules-based active strategies, rather than achieve beta, or average market return, through broad exposure to the market," said Vanguard investment analyst and co-author Scott Pappas.
"The term smart beta implies that these funds capture higher returns using rules that are more intelligent than the rule of tracking a broad market cap-weighted benchmark," Mr Pappas said.
"Some factor tilts may outperform a comparable broad market index over time, but it is more accurate to say that these rules-based active strategies perform differently to the market, rather than performing better than the market."
Investors who use smart beta (or 'factor-based') strategies need to be patient because all factors – value, size (small cap), low liquidity, quality, momentum and volatility – underperformed at some point between 2002 and 2015, Mr Pappas said.
"In fact, all six factors saw periods of underperformance longer than 60 months, and all underperformed the broad market by at least 7 per cent over a 12-month period," he said.
Investors are better off using factor-based strategies to complement their existing portfolios rather than as a tool to chase returns, Mr Pappas said.
"For example, an investor who wants exposure to undervalued companies might favour a value factor, whereas an investor who is more conservative and wants to manage risk might opt for a low volatility factor," he said.
“Investors should consider factor strategies that match their investment objectives, rather than trying to identify a sure-fire solution for outperformance.
"Using a factor strategy to tilt at certain equity characteristics can be an effective way of achieving better portfolio outcomes, from weathering volatile markets to capturing long-term growth opportunities."
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