The overlooked differences between factor investing and smart beta

Less-than-exact knowledge of factors could lead to ill- defined performance expectations

The overlooked differences between factor investing and smart beta

With the rapid growth and innovation throughout the ETF industry, it’s become common for financial professionals to use the terms “smart beta” and “factor investing” interchangeably. But experts say that switching of terms actually points to a growing cloud of confusion around what drives investment outperformance.

Rob Arnott, founder and chairman of Research Affiliates, recently explained to that smart beta was coined by consulting firm Towers Watson in 2007. The inspiration behind it was fundamental weighting, a strategy that trims positions in companies whose prices rise drastically without a change in their fundamental value, and increases holdings in companies with falling prices and unchanged value.

“[T]he term became popular because pretty soon everybody was wanting to say ‘we're studying smart beta,’” he said.

Factor investing, meanwhile, was based on academic work at the University of Chicago by Kenneth French (now at Dartmouth) and Eugene Fama. They looked at five main factors associated with higher returns: value, small-caps, momentum, low volatility, and quality. Since then, yield has occasionally been counted as a sixth main factor.

According to Arnott, the factor community adopted the term smart beta because the fundamental weighting strategy, which buys out-of-favour companies, has a value tilt. But since factor investing strategies traditionally begin with a market capitalization weighting, he argued that such strategies aren’t smart beta. And while factors can be used in tandem with fundamental weighting, that makes sussing out the primary driver of performance tough.

Another difference: smart beta is usually a long-only strategy, while factor strategies can be long or short. Mark Carver, executive director for Americas index products at MSCI, explained that factor portfolios can have an investor long on equities that do well and short on names that do poorly, with the difference between those two as the factor return.

Carver added that organizations like MSCI have decades’ worth of empirical evidence to support factors that they think earn a reward over time such as value, momentum, and quality. “We're building indexes against those factors … and that’s different than what you're doing in smart beta, which could be just trying to get a thematic idea that may or may not hold up to long-term rigorous evidence,” he said.

Weighing in on the factor issue, Toroso Investments Chief Investment Officer noted the use of non-academically defined factors such as ESG tilts and share buybacks. Some of those may not have as rigorous research, he said, but they still might be considered factors.

Adding to the problem, said IndexIQ Chief Investment Officer Sal Bruno, is the use of factors that go outside the scope of the Fama-French research. “The pure factor is important from a research and academic perspective, because if you don’t do that, you end up including too much of the market effect, which is its own factor,” he said.


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