First of all, we wish to thank the investment practitioners who have contributed to this book. We are grateful that they took time out of their busy schedules to share their experiences relating to smart beta investing. We hope that readers will find their contributions insightful and useful.

We wish to recognize the valuable contributions and assistance provided by the following reviewers: Andrew Alford, Stephan Kessler, and Joseph Kushner.

We also wish to thank the following individuals for their insightful comments and guidance during the review process: Leyla Marrouk, Prafulla Saboo, Katie Souza, and Aicha Ziba.

Finally, this book would not have been possible without the editorial and organizational assistance of Patricia Berman and Ingrid Hanson.

The views and opinions expressed in this book are those of the authors and do not necessarily reflect the views or position of any asset manager or entity the authors may be affiliated with. They are provided for informational and educational purposes only and do not constitute (and should not be relied upon as) any investment advice or recommendation. Views and opinions are current as of the date of publishing and may be subject to change. All investors are strongly urged to consult with their legal, tax, or financial advisors regarding any potential transactions or investments.

Equity smart beta and factor investing has become a highly discussed and debated topic within the industry over the last few years. Indeed, investor surveys consistently highlight not only the increasing popularity but also adoption of smart beta investing. As an example, in the FTSE Russell 2018 Global Survey Findings from Asset Owners, which surveyed asset owners representing an estimated $3.5 trillion in assets across North America, Europe, Asia Pacific, and other regions, 77% of asset owners responded that they have already implemented, are currently evaluating implementation, or plan to evaluate smart beta strategies in the near future. The survey also found that smart beta adoption rates increased from 26% in 2015 to 48% in 2018. More interestingly perhaps, while FTSE Russell surveys in previous years showed a significantly higher adoption rate for large asset owners with more than $10 billion in assets, in this most recent survey, the adoption rates were more evenly distributed across small (39%), medium (43%), and large (56%) asset owners. In terms of adopted smart beta strategies, multifactor offerings showed the highest adoption rate (49%), followed by single factor low volatility (35%) and value strategies (28%). The growth in the adoption rate of multifactor offerings, most likely driven by a better understanding of the diversification benefits offered by a combination of lowly correlated equity common factors, appears to come at the expense of other smart beta strategies that have concentrated exposures to certain factors, such as fundamentally weighted strategies, which have seen adoption rates decline from 41% in 2014 to 19% in 2018.

In our opinion, smart beta is an important innovation in the field of investments, and its growing adoption across the industry is driven by many considerations. First, in our experience, many public and private pension plans have a 6% to 8% return requirement from their investment portfolio (actuarial rate of return) in order to meet their expected liabilities. In a low expected return environment, such return targets may become difficult to achieve without significantly increasing the allocation to equities. At the same time, some asset owners also have a desire to lower the volatility of the overall investment portfolio as well as the volatility in funding contributions and earnings, while retaining the equity allocation. Asset owners, therefore, appear to be confronted with conflicting objectives: (1) improve portfolio returns, but without increasing the equity allocation and/or (2) reduce portfolio volatility, but without lowering the allocation to equities. Smart beta investing may provide potential solutions to meet these goals. Certain smart beta offerings, such as multifactor strategies, offer the potential to improve expected returns, while keeping portfolio volatility at a level similar to that of the market. Certain other smart beta offerings, such as low-volatility strategies, provide the potential to lower overall portfolio risk, while seeking to generate market-like returns. As such, smart beta investing may allow investors to meet the objectives of return enhancement and/or risk reduction, without meaningfully altering the equity allocation.

Second, the introduction of smart beta investing, alongside active management, offers the potential to significantly improve the diversification benefits in a portfolio. Indeed, in combining smart beta with true alpha, investors can introduce multiple layers of diversification, which drive important efficiency gains (i.e. higher relative risk adjusted returns) in the overall portfolio.

Third, in our interactions with large asset owners, we find that, as the portfolio size grows, it may become progressively more difficult for these asset owners to find additional skilled active managers and/or increase the allocations to the best performing managers, as manager concentration may lead to capacity and/or manager risk constraints. Such asset owners are confronted with the problem of delivering a reasonable alpha on a large and growing asset base. In our experience, these asset owners have tended to look at certain smart beta strategies, mainly low tracking error multifactor offerings, as transparent and systematic strategies capable of delivering alpha (excess returns relative to the market portfolio) with high capacity and cost-efficiency.

Fourth, from an investment process point of view, the increasing popularity of smart beta investing can also be attributed to the fact that it seeks to combine the most attractive features of both active and index investing. Smart beta offerings often seek to capture the same sources of excess returns (i.e. factors) that active managers commonly emphasize, and that have depicted persistent market outperformance. But unlike active management, these sources of excess returns are now delivered in index-like approaches, which aim to mitigate investment process and transparency risks and provide meaningful implementation cost and management fee savings.

Fifth, as product structurers have more or less exhausted offerings based on capitalization-weighted indexes, their focus has shifted to smart beta indexes and associated products. According to Morningstar Research (2017), “A Global Guide to Strategic-Beta Exchange-Traded Products,” strategic-beta (Morningstar's terminology for smart beta) exchange-traded products (ETPs) were introduced in the United States in May 2000. As of June 2017, strategic-beta ETPs had grown to 1,320, with aggregate assets under management of US$707 billion worldwide. In fact, the rate of growth in strategic-beta ETPs and associated assets has accelerated in the recent past. For instance, from June 2016 to June 2017, strategic-beta ETPs recorded an increase in inflows of 28.3%.

Moving forward, based on our discussions and experiences with clients, we expect growth in smart beta investing to continue. For retail investors, structured smart beta products, priced significantly below traditional active and close to traditional passive, in our opinion, are likely to attract the majority of allocations. For institutional investors, although the starting allocations to smart beta are small, we expect a typical equity portfolio structure to comprise 50% capitalization-weighted passive, 25% smart beta, and 25% active in the long run. At the same time, we also note that many investors have not yet adopted smart beta investing. According to various surveys, such as the FTSE Russell 2018 Global Survey, the need for better education on topics such as how to approach and position smart beta, how to analyze and conduct due diligence, on the large number of smart beta offerings, and how to determine the best strategy or combination of strategies for a given portfolio structure, remains the most important barrier for investors to implement smart beta investing.

The need for continued investor education provides the motivation for this book. Our hope is that investment practitioners will find the content of this book relevant and useful in understanding the theoretical underpinnings of smart beta investing, analyzing and selecting appropriate smart beta strategies that meet their specific objectives, structuring more efficient portfolios by incorporating smart beta with true alpha, and, perhaps most importantly, gaining insights from other practitioners who have successfully implemented smart beta investing in their portfolios.

Overview of Book Chapters

In Chapter 1, we start by reviewing the evolution of the equity smart beta space as well as some desired characteristics of smart beta offerings. This review of the evolution of smart beta investing provides useful insights in understanding the definition and current composition of the smart beta space.

Since smart beta has over time become closely aligned with factor investing, in Chapters 2 and 3 we provide an overview of equity common factors and factor investing. Chapter 2 briefly reviews the origins and theory of factor investing. We also address topics such as why investors should care about equity factors and which specific factors have become the focus of various smart beta offerings. Chapter 3 focuses on explaining smart beta factor return premia. We discuss the risk-based, behavioral, and structural explanations for why factor premia exist, why they have persisted historically, and why they can be expected to persist going forward.

The wide variety of smart beta products available in the marketplace can sometimes be overwhelming for investors, who often struggle with how to analyze and select such products. Differences in smart beta offerings can arise from many sources, such as factor specifications, weighting schemes, and methodologies used to control turnover, diversification, or capacity. The various considerations involved in capturing smart beta factors and selecting smart beta strategies are discussed in Chapters 4, 5, and 6. In Chapter 4, we propose a simple framework for understanding some of the various weighting schemes employed to capture smart beta factor returns. We also analyze the efficiency in factor capture achieved by these weighting schemes. In Chapter 5, we discuss some of the various factor signal specifications that are commonly used in the design of smart beta products. In addition to the choice of the weighting scheme, factor signal specifications can also drive differences among the various smart beta offerings. And in Chapter 6, we analyze a large number of publicly available smart beta strategies, using the factor portfolios we construct in Chapter 4. Although our focus is on smart beta strategies, we also use these factor portfolios to conduct a risk decomposition of certain active strategies. The analysis conducted in this chapter provides useful insights in understanding the drivers of performance for smart beta and active strategies as well as assessing the efficiency of factor capture or the existence of manager skill more generally.

In Chapters 7, 8, and 9, our focus shifts to understanding the performance characteristics of smart beta factor strategies. We start by analyzing the historical performance of individual smart beta factor portfolios in Chapter 7. We discuss performance across three regions, namely, US, Developed Markets ex. US, and Emerging Markets. We adjust performance for implementation costs in order to make historical simulations potentially more representative of “live” implementation. This chapter seeks to provide insights into how factors differ in terms of their total and relative risk and return attributes as well as their performance in different market regimes. In Chapter 8, we move from individual factors to factor diversification strategies. We discuss the attractive correlation attributes of smart beta factors and show how combining factors results in improved relative risk-adjusted performance, while also potentially mitigating market underperformance risk. It is often said that diversification is the only free lunch in finance. Multifactor smart beta strategies may well represent an example of the significant benefits that can be achieved through diversification. In Chapter 9, Roger Clarke, Harindra de Silva, and Steven Thorley provide an insightful discussion relating to low-volatility investing. The authors review (1) the historical performance of the low volatility factor and explanations advanced to explain it, (2) whether the anomaly is driven by systematic or idiosyncratic risk, (3) the characteristics of the low volatility factor, such as correlation with other factors, and (4) techniques commonly used for building low volatility portfolios.

With regard to smart beta implementation and portfolio structuring, Chapter 10 analyzes various potential challenges that investors face in designing multistrategy, multimanager portfolios. These challenges partially arise from current portfolio structuring practices, which, in our opinion, do not provide adequate guidance on how to implement efficient style and manager diversification. Therefore, we propose an alternative portfolio structuring framework that seeks to improve on current practices by facilitating the building of potentially more efficient overall portfolio structures that incorporate smart beta strategies alongside active management.

Investors have an increasing desire to reflect environmental, social, and governance (ESG) values and perspectives in their overall equity portfolios. In Chapter 11, we propose a framework for incorporating ESG factors as well as combining ESG factors with smart beta factor investing. The framework emphasizes customization and transparency in performance attribution, while maintaining some degree of benchmark-awareness.

Chapter 12 provides an example of the application of factor investing beyond equities. In this chapter, Oliver Bunn outlines a factor-based approach to identifying the systematic risk exposures taken by hedge funds. These economically intuitive factors based on academic research are well-defined, liquid, and can be implemented at relatively low cost. A portfolio of these systematic factors can provide investors with access to a hedge fund-like return profile.

The remainder of the book chapters comprise contributions from practitioners who have successfully implemented or are considering implementing smart beta investing in their equity portfolios. Asset owner perspectives are provided in Chapters 13 through 15. The implementation of smart beta at California Public Employees' Retirement System (CalPERS) is discussed by Steve Carden in Chapter 13. The evolution of the smart beta program at CalPERS constitutes an interesting case study because it closely mirrors the evolution of smart beta investing in the industry, in general, from an alternative beta strategy to multifactor investing. In 2006, CalPERS adopted fundamental indexation as a mean-reversion strategy that could potentially address the perceived shortcomings of a trend-following market capitalization-weighted portfolio. As fundamental indexation was implemented and monitored over the next four or five years, an understanding was gained that the excess returns of this strategy were driven by a high exposure to the value factor. This exposed the portfolio to the significant cyclicality of value returns. As a result, over time, the focus shifted toward diversifying the value exposure with other factors, such as momentum, quality, and low volatility, which have a low or negative correlation with value but independently deliver positive excess returns in the long run. CalPERS was also an early adopter of a hybrid implementation model, which combines active and index management for implementing systematic smart beta and factor strategies. In this model, external strategies are sourced from smart beta managers as a custom index through a licensing agreement and replicated in-house by CalPERS. The hybrid implementation model has resulted in meaningful trading cost and management fee savings for CalPERS. In the next case study in Chapter 14, Hans de Ruiter discusses the design and implementation of a smart beta program at the Pensionfund TNO. Historically, TNO had allocated to equities in a passive fashion using traditional index funds. The advent of smart beta offerings provided an opportunity to include additional sources of excess returns in order to potentially improve the risk-adjusted performance of the portfolio. As such, Pensionfund TNO approached smart beta as a form of enhanced indexing that would allow the fund to partially transition the portfolio from a single-beta to a multiple-beta passive strategy. In considering smart beta, Pensionfund TNO laid out the important questions that needed addressing, such as: Which smart beta factors to focus on and why? Which smart beta strategies to consider if mitigating short-term market underperformance risk is an important objective? How to address persistence of smart beta factor premiums at a practical level? How to construct multifactor smart beta strategies? How to assess and mitigate the impact of implementation costs? And which benchmark to use for the implemented smart beta strategies? This case study provides useful insights into how Pensionfund TNO addressed these questions. Another early adopter of smart beta factor investing is the Barclays Bank UK Retirement Fund (BUKRF). In Chapter 15, Ilian Dimitrov explains how smart beta over the years has contributed meaningfully to improve the risk-adjusted returns of the overall equity allocation. Initially, at BUKRF, smart beta was used for portfolio completion and exposure management purposes with the goal of achieving a diversified and balanced exposure to certain targeted factors. In recent years, the use of smart beta has broadened to include strategies that capture a specific risk premium at low cost as well as multifactor strategies that serve as an alternative to active management in highly efficient segments of global equity markets. This case study also discusses the various challenges faced by BUKRF in the implementation of their smart beta program, the criteria used in selecting appropriate smart beta strategies, the process used to determine an allocation to smart beta, and the various considerations relating to governance, monitoring, and performance benchmarking of smart beta strategies.

Chapters 16 and 17 provide investment consultants' perspectives on smart beta. Although some investment consultants have not formed a formal, public view on smart beta investing, others, such as Willis Towers Watson (WTW), have been early advocates of such strategies. In Chapter 16, James Price and Phil Tindall from WTW discuss smart beta from an asset owner's perspective. The authors argue that smart beta has resulted in a meaningful change in the investment landscape for asset owners as it shifts the emphasis from manager selection to investment strategy selection and, hence, requires a different set of skills. Smart beta requires increased up-front governance, which also means that asset owners need to form beliefs regarding smart beta, distinguish between absolute and relative return worlds, and avoid short-termism in strategy evaluation and monitoring. In this new world, asset owners also face some challenges, such as potential crowding of smart beta factors and timing allocations to strategies, which they will need to address. In the US, Wilshire Consulting have also been one of the early advocates of smart beta investing. In Chapter 17, Andrew Junkin, Steven Foresti, and Michael Rush discuss the perspectives of Wilshire Consulting with regard to smart beta. They argue that investors consider adopting smart beta as a replacement for or complement to active management, as smart beta captures many of the systematic sources of returns that active managers also implement, but does so in a systematic, transparent, and less expensive manner. Smart beta may also be appropriate as a replacement for traditional passive for those investors who are looking to improve risk-adjusted returns of their portfolios but wish to achieve that at a reasonable cost. In the end, Wilshire Consulting believes that smart beta strategies potentially represent an effective solution for those asset owners wrestling with the current low expected return environment.

Chapters 18 and 19 focus on the potential motivations for retail investors to consider smart beta investing. In Chapter 18, Lisa Huang and Petter Kolm at Fidelity Investments and Betterment, respectively, lay out the case for retail advisors to offer a complete smart beta solution to their clients. Supported by academic evidence and declining costs of implementation via exchange traded products, the authors argue that smart beta strategies represent an interesting vehicle for building more efficient and cost-effective portfolios in the retail space. In Chapter 19, Jerry Chafkin from AssetMark addresses the potential positioning of smart beta with retail investors. In his opinion, smart beta is a disciplined and systematic approach to alpha generation, which facilitates the basic objective of active management, but with greater reliability and transparency. Smart beta is a compelling proposition for retail investors because it combines the advantages of both passive (low-cost, disciplined, and transparent) and active (potential for market outperformance) investing. One of the most important appeals of smart beta investing is that as systematic strategies they help both investors and managers set appropriate expectations and maintain discipline during difficult times. This potentially significantly improves the ability to achieve investor objectives in the long run.

Finally, Chapters 20 and 21 provide some concluding remarks, including addressing some skepticisms regarding smart beta investing.