When it comes to optimising performance, an investment portfolio is like a Formula One racing car: each element added impacts other critical aspects of performance. Simply plugging in a basic off-the-shelf smart beta solution to reduce costs or control a particular investment exposure doesn’t necessarily work. You need to consider all the flow-on effects, interrelationships, risks and performance implications of the new strategy on your overall portfolio.
Every part of a Formula One racing car, from the front engine through to the rear spoiler, is designed to integrate seamlessly. As they prepare for a race, Formula One engineers are focused on maintaining the right aerodynamic balance for the car to perform at the optimal level. They consider every single surface of the car, such as the angle of the suspension links and the shape of the driver's helmet, in terms of its aerodynamic effects.
Getting the right balance is critically important for maximising the optimal speed around the track, through corners, sweeping bends and along straights. If an engineer adjusts one part of the car without carefully considering its impact on other aspects of the cars set up, it could compromise safety and perfofrmance.
Optimising the total performance – all the parts are connected.
The same is true of an investment portfolio. You may start with a portfolio that has been ‘balanced’ to pursue a particular objective. If you try to ‘tune it’ by adding a new strategy, other elements of the portfolio may be thrown off balance. For example, increasing exposure to investments that offer higher dividend yields may also change the overall portfolio exposure to the value factor. This may or may not help achieve your overall investment goals, depending on market conditions and the rest of your portfolio positioning.
The rising popularity of smart beta strategies amongst institutional investors in recent times reflects investors’ desire to control portfolio exposures and outcomes in cost effective ways. Smart beta solutions are transparent, rules-based strategies that are constructed to provide non-capitalisation weighted investment exposures. Depending on the type of smart beta solution, they are designed to capture specific investment beliefs, behavioural anomalies or market inefficiencies.
However, smart beta is not a silver bullet that can be simply plugged into a portfolio. Any additional strategy, smart beta or otherwise, brings with it an embedded combination of factor exposures. This in turn impacts the return and risk characteristics of the overall portfolio. Adding a smart beta strategy to a portfolio can alter tracking errors, change expected excess return or affect factor/industry/stock bets. Portfolio managers need to understand and take into account each of these impacts before adding the new strategy. Specifically, investors must first understand and assess the:
- Portfolio objectives
- Existing portfolio risk characteristics, including existing factor exposures
- Portfolio construction methodology used to generate the smart beta strategy
- Actual factor exposure profile of the smart beta strategy
- Impact on the total portfolio of integrating the smart beta strategy
- Performance expectations across a range of marketf environments.
Part of the issue is that not all smart beta strategies are created equal. Even where two smart beta strategies claim to provide exposure to the same factor, they can have significant differences in the way the factor is defined and the methodology used to generate the desired exposure. In turn, this can lead to significant differences in performance characteristics and the way each strategy impacts the broader portfolio.
Just as Formula One drivers rely on different tyres to handle different road or weather conditions, so institutional investors need to select the right smart beta strategy, at the right time to best meet their goals and maximise performance in different market environments. Otherwise, smart beta can become more of a distraction than a solution.
The power is in the approach
Institutional investors concerned with the underlying factor exposures within their portfolios need to avoid simply plugging in smart beta and instead take the time to consider customised rules-based solutions.
Merely substituting active management for smart beta is akin to using generic tyres without considering how they will impact the overall speed, handling and safety of the car. The generic tyres might be fine for a family car to do the grocery shopping or take the kids from A to B. But these same tyres will create significant risks and unintended consequences when applied to a racing car designed for a high stress, high performance Formula One track environment.
Similarly, for investment portfolios, performance is determined by the combination of focus on the exposures to be added, plus their interrelationship with the exposures already there. Hence the real solution to institutional investment needs lies not in the tool called smart beta—or in any other single tool for that matter—but rather in a multi-faceted solution approach.
Such an approach draws on multiple tools and combines them in a customised way. This allows the portfolio to adapt to changing conditions and incorporate new elements without compromising performance.
Just as a Formula One engineer uses a host of tools and tuning elements to optimise performance, the optimal portfolio toolkit includes customisable factor portfolios to provide the desired exposures, together with a complementary range of implementation and exposure management tools to help manage the risk of unintended consequences in the broader portfolio. This allows institutional investors to create a portfolio where they can actively manage underlying factor exposures.
Yet unlike in the racing world, where ‘customisation’ is code for ‘expensive’, this customised investment approach is cost efficient. By leveraging smart beta solutions in an intelligent way, together with other tools and investment options, it both reduces costs and improves portfolio performance.