Is smart beta investing a lottery?

How have smart beta investing strategies performed over the years, and what has caused certain styles to outperform others?

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Smart beta investing

What is a smart beta?

Smart beta, also known as factor investing, involves passive investment strategies that differ from investing in a traditional, market capitalisation—weighted stock index. Smart beta strategies are based on certain rules that give investors exposure to certain investment styles that explain risk and returns within the stock market.

The most common styles are low volatility, quality, value, momentum, size and dividend yield. Each of these smart beta strategies tend to perform differently at various stages of the economic cycle and in certain market environments. You can read more about each of these styles here.

Have these strategies beaten the market?

The graphic below shows how each style has performed relative to its market cap—weighted index over the past five years. For this we used the MSCI World Total Return series, which covers the global equity market.

Table 1: Smart beta returns relative to the market


Minimum volatility: slow and steady wins the race?

Back in 2008, the MSCI World Minimum Volatility Index was the top performer, beating the standard MSCI World Index by 11%. This style seeks to reduce portfolio risk by selecting a basket of stocks that tend to be larger companies with more stable earnings and less debt on the balance sheet. Since these companies tend to perform better than most during market downturns, it is no surprise that this was the winning strategy during 2008.

However, when the global stock market started to recover the following year, this defensive style underperformed the market by 13.6% as equities began to bounce back. This demonstrates how alpha generated by a smart beta style one year can easily be wiped out the next as market conditions change. With a recent rise in equity volatility and continued fears that valuations look stretched, iShares Edge MSCI World Minimum Volatility — which made our Top 50 ETFs for 2018 — gives investors access to this strategy with an annual cost of just 0.30%.

Looking over the longer term, it is clear that some styles have outperformed others. The chart below plots returns for each style since 2008.

Chart 1: Smart beta returns since 2008


While the previously mentioned low volatility factor has beaten the market by 22.6% since 2008, momentum and quality styles also stand out as outperformers.

Momentum: recent winners surge ahead

Throughout 2017 and during the first quarter (Q1) of 2018, the momentum strategy (yellow line) has been the star of the show, outperforming the market by over 14%. This strategy essentially invests in stocks that have recently gone up in value, with the view that this trend will continue into the future.

Money poured into FAANG stocks (Facebook, Amazon, Apple, Netflix and Google) throughout 2017. The recently named ‘WNSSS’ stocks (Weibo, Nvidia, ServiceNow, Shopify and Square Inc) have also seen spectacular share price gains of late, and are tipped to be the next tech sector winners. But for how long these companies can grow, let alone support, current lofty valuations is the multi—billion dollar question.

Quality: will predictable earnings steams and less geared balance sheets be the winning combination?

When things get shaky in financial markets, companies that exhibit a combination of high returns on equity (ROE), low debt—to—equity ratios and stable earnings per share (EPS) are thought to be better positioned to outperform the broader market.

The rise in equity volatility earlier this year has taken the sheen off the bull market somewhat. At the time of writing, the MSCI World Index is broadly flat year—to—date with the Volatility Index (VIX), remaining above levels last seen back in August 2016. However, as Table 1 above shows, quality stocks outperformed in Q1 and have done in all but two of the previous ten years.

The chart below (inspired by BlackRock) plots the VIX, along with the relative return of the MSCI USA Quality against the MSCI USA Index. It illustrates how the majority of the outperformance of quality stocks has been generated when volatility has risen sharply.

Chart 2: Do quality stocks outperform when volatility increases?


You can find smart beta exchange traded funds (ETFs) using our ETF Screener. These generally include in the name ‘value’, ‘momentum’, ‘dividend’ etc. If you find an ETF that you would like to invest in, you can do this in IG’s share dealing platform. You can compare our share dealing fees here.

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