Creating Alpha Using Beta is Smart! – Lynne Kinney

By: Lynne Kinney, CKW Financial Group

“Smart Beta defines a set of investment strategies that emphasize the use of alternative index construction rules to traditional market capitalization based indices. Smart beta emphasizes capturing investment factors or market inefficiencies in a rules-based and transparent way. The increased popularity of smart beta ETF’s s linked to a desire for portfolio risk management and diversification along factor dimensions as well as seeking to enhance risk-adjusted returns above cap-weighted indices.”*
The problem with Smart Beta is it creates a portfolio based on rules and factors and compares the portfolio built against a benchmark with different rules and factors.  So building a portfolio with rules and factors that outperforms another portfolio with different rules and factors will give you a Smart Beta product.  In pursuit of reducing Beta and increasing return relative to the S&P 500, the industry has singularly focused on comparing itself to something different.  Remember Long Short Hedge Funds comparing themselves to the S&P 500, then bonds because they no longer beat stocks.  A long short fund should beat a passive index of buying the S&P 500 and buying at the money puts.

Mathematically a different beta means a different portfolio.  Investors like upside beta and not down side Beta.  No beta no return.  So we need to use beta to get alpha and not try to control beta.  CKW believes it is easier to reduce downside volatility and keep return constant versus increasing upside return and keeping volatility the same.  For long-term investors, it is easier to see and sense danger than it is to chase high returns.  Chasing returns requires a talent to time the top or get close (market timing); avoiding what seems expensive or dangerous requires patience (time in the market).

Alpha like Beta can only exist if something is different.  Nothing is perfect, so where is the line on how different you can be from the benchmark before someone screams no fair?  It seems to us that 15% over/under is enough to create alpha using beta.  Remember that 90+% of variability could be explained by asset allocation (with just 2 assets equity and fixed income).  Like sports we should use the large muscles.  In a balanced investment portfolio the large Beta muscles trades are equity vs. fixed income, domestic vs. international, cap, style, and a few others related to fixed income, but you get the picture.  Too many active parts lead to unintended unmeasured consequences because many managers of active managers assume, hope, and pray that each active manager will beat its intended benchmark.  Security interaction and manager interaction is not measured and frankly statistically unpredictable.  Let’s use our big muscles and use Beta to create Alpha in a smart way.

* Investopedia’s definition of Smart Beta – http://www.investopedia.com/terms/s/smart-beta.asp