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Smart Beta

What Is Smart Beta?

Smart beta refers to investment strategies that differ from traditional capitalization weighted indexing or actively managed investment approaches. Smart betas are based on empirical data or live historical research and may offer superior performance relative to more traditional indexation methods. Having a transparent quantitative method for portfolio construction further deviates from traditional cap weighted or equal weighted indexes and reduces the investment costs to creating this type of strategy due to its transparency and the fact that it can be managed in a more systematic fashion than traditionally active managed funds. Smart beta strategies are based on over 250 known factors that are constantly experiencing turnover as new factors that positively influence investments are being discovered and dusty underused factors are being retired. In any given year there are over 40 factors found using quantitative methods by researchers, finance professors, and fund managers, that promise to provide excess return to a traditionally managed portfolio. Portfolios are constructed by running regressions as well as other statistical tests on historical data in order to backtest the given strategy on what has actually happened in the markets. The chart shown below indicates that the top 20% of stocks from the S&P 500 as ranked by the original "beta" (that won Professor William Sharpe the Nobel Prize in 1990 for the Capital Asset Pricing Model) would have returned about 9% per year when reselected and rebalanced every four weeks between 1999 and 2018.

What Factors Are Best?

When considering different factors to add to a portfolio, investors must determine how much and what types of risk they are willing to be exposed to. For example volatility risk or risk relative to the benchmark index are two different types of risk that represent different tradeoffs. A risk premium that tracks the benchmark, known as tracking error can respond negatively when there is high volatility in the market. The same thing occurs vice-versa; an index that hedges volatility risk might be more exposed to a higher tracking error and may not rise with an index (such as the S&P 500) as much as an index point tracker like SPX. Other types of factor differentiators to consider include time and geographically varying factors as well as fund type. Astute managers attempt to diversify across these various dimensions. Examples of these  styles include large cap growth, foreign small cap, developed international, emerging markets, as well as various sector oriented and thematic approaches. Other investment vehicles used by JQR Capital include ETFs, low risk yet consistent income bond portfolios, fundamental portfolios based on analysis of public company information such as dividends, sales, cash flows and book value. Geographically oriented portfolios include Latin America, BRICS, Emerging markets, and European oil and gas. The second chart shows the power of applying a "smart beta" weighting system to select the top 20% of stocks from the S&P 500 as ranked by the JQR Capital Multifactor Equity Ranking System. This strategy would have returned about 12% per year when reselected and rebalanced every four weeks between 1999 and 2018.

Why Invest Using Smart Beta?

Given the systematic risks involved, we believe that the evidence shows that smart beta factors can lead to higher expected returns relative to market cap benchmarks, and thus, we are proud to offer portfolios for customers with long investing horizons and a high degree of comfort with the risks involved. While a jump from a 9% annualized return (first chart) to a 12% annualized return (second chart) may not seem very dramatic, this final chart shows the cumulative effects of compounding when applying such a smart beta strategy between 1999 and 2018. The portfolios created from the top 20% of the S&P 500 outperformed the underlying index by about a factor of 7 to 2. Who would not want to have 3.5x as much in their portfolio 20 years from now?

Important Disclaimer

Past performance is no guarantee of future results. Any investment involves some amount of risk and may not be suitable for all — or any — individuals. You should consult with your investment advisor before acting on this — or any — financial information.

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