Beyond Active and Passive:
Using Smart Beta Strategies
to Build More Efficient
Portfolios
EXECUTIVE SUMMARY
By William Cazalet, CAIA
Managing Director
Global Investment Strategist
Mellon Capital Management
Smart beta strategies
may be compelling
complements to both
passive strategies
and conventional
active strategies.
Smart beta strategies can be thought of as forms of active
management because they take positions that often differ
significantly from market capitalization-weighted benchmarks.
They differ fundamentally from traditional active strategies,
however, in that they typically use a rules-based process and are
designed to be transparent. These characteristics mean that
smart beta strategies may be compelling complements to both
passive strategies that track market capitalization-weighted
benchmarks and conventional active strategies that seek to
outperform those benchmarks.
Passive strategies are inexpensive, transparent and designed
to deliver beta exposures, either to the broad market, narrow
regions, countries or sectors. Active strategies are designed
to compensate for at least some of the biases of market
capitalization-weighting by overweighting stocks with attractive
fundamental characteristics that have the potential to deliver
an excess return. The power of smart beta strategies lies in
their ability to combine compelling elements of both active
and passive approaches into a single package. Like passive
strategies, smart beta strategies deliver beta exposure in a
cost-effective and transparent manner. At the same time,
they also offer the potential for excess returns and/or lower
volatility than the cap-weighted benchmarks that characterize
traditional active strategies.
BEYOND ACTIVE AND PASSIVE:
USING SMART BETA STRATEGIES //
2
Smart beta strategies
deliver beta exposure
in a cost-effective and
transparent manner.
The first generation of smart beta strategies were simple
approaches that usually either featured a single portfolio
“tilt” toward a factor such as value or size, or used techniques
that focused on narrow definitions of risk such as minimum
variance. While many smart beta strategies still seek to capture
these factors, Mellon Capital has sought to diversify portfolio
tilts by adding quality and momentum factors. Including these
factors delivers a more “core” smart beta strategy that offers
downside risk control, while retaining the original smart beta
characteristics of transparency, diversification and low-cost.
WHAT IS SMART BETA?
“Smart beta” is a term1 applied to the comparatively new strategies that capture risk
premia from one or more asset classes in a systematic and transparent fashion. The
term “beta” may be defined in a number of different ways. For example, we define the
beta of a stock or a portfolio as a measure of its risk relative to the market as a whole.
We also refer to beta as the market performance (the return of a specific benchmark
based on a particular asset class or classes) that can be achieved in a very costeffective manner via a passive investment. One of the issues with a portfolio that
represents the market as a whole is that the stock positions it holds are weighted by
market capitalization. This means that a stock’s weight in the portfolio increases as
it outperforms the overall market. As a result, stocks that are more expensive than
the market are held as overweight positions in the portfolio.
Smart beta strategies aim to break the link between the price of a stock (or other
security) and its weight in a portfolio. The term “smart beta” is therefore somewhat
misleading, because smart beta portfolios are not intended to offer beta in the
traditional sense by being passive or mirroring the return of a traditional market
capitalization-weighted portfolio. Because smart beta strategies seek to escape
the constraints of capitalization-weighting in portfolio construction, investors
should view them as more transparent forms of active management.
1Other terms may include scientific beta, fundamental indexing, custom beta, strategic beta,
systematic beta, and advanced beta.
BEYOND ACTIVE AND PASSIVE:
USING SMART BETA STRATEGIES // 3
Smart beta is often compared to enhanced indexing. That comparison is
reasonable, but it can also be misleading. The comparison is reasonable because
both types of strategies tend to be used by systematic asset managers as lowercost means of gaining exposure to specific markets. But the comparison is also
misleading because smart beta strategies ignore market capitalization, unlike
enhanced index, passive and traditional active strategies that are based on market
capitalization indices. And while enhanced index strategies typically do not deviate
far from benchmark weights, they tend to rely on proprietary information and lack
the transparency that is an essential part of smart beta strategies.
THE ORIGIN AND CHARACTERISTICS OF SMART BETA
Smart beta derives from the realization that risk premia in asset classes could be
more efficiently captured by taking an approach different to that used in market
capitalization-based indices. Proponents of smart beta strategies argue that
market capitalization-weighted portfolios tend to overweight overvalued securities
while underweighting undervalued ones. Therefore, a security whose price has
risen beyond its fair value will have a greater weight in a traditional cap-weighted
index while a security trading below its fair value will have a lesser weight in that
index. Smart beta strategies break this automatic connection between an asset’s
price and its weight in a specific benchmark.
Market capitalization-weighted portfolios, especially those based on larger
capitalization stocks (i.e. the S&P 500®), are also overweight in so-called
mega-capitalization names, whose performance dominates the performance
of the overall index. Smart beta strategies seek to reduce concentration through
the portfolio construction process.
Besides dispensing with market capitalization as an anchor in any weighting
scheme, smart beta strategies also typically have three characteristics in common.
First, smart beta strategies are implemented in a systematic fashion. They follow a
pre-defined set of rules in order to construct a portfolio. In addition to those rules,
strategies can also be customized to suit the particular objectives of an investor.
For example, additional guidelines may be added that govern socially-responsible
investing or require particular fundamental data as inputs. Second, smart beta
strategies are extremely transparent because they are constructed systematically
and use clearly identifiable rules and characteristics. Third, the systematic and
transparent nature of smart beta strategies means they can be implemented at a
low cost. Regardless of their construction, smart beta strategies take exposures
that are different from passive, cap-weighted benchmarks. We therefore view
smart beta strategies as active in nature.
Investors should view
smart beta strategies as
more transparent forms of
active management.
BEYOND ACTIVE AND PASSIVE:
USING SMART BETA STRATEGIES //
4
TYPES OF EQUITY SMART BETA STRATEGIES
Most equity smart beta strategies can be grouped into two categories. In the
first group are strategies that seek added return from one or more fundamental
characteristics, such as earnings yield, cash flow, or dividends. In the second
category are strategies that focus more on managing risk, whether they seek
to deliver a portfolio that has the lowest possible overall volatility or one that
seeks to deliver greater diversification.
Smart beta strategies
follow pre-defined
rules in order to
construct portfolios.
FUNDAMENTALS-BASED STRATEGIES
Perhaps the most common type of fundamentally-based smart beta strategy seeks
to add value through a single (or small number of) fundamental measure(s) such
as sales, earnings, dividends, or book value—as opposed to market capitalization.
Stocks with relatively higher fundamental measures are weighted more heavily in
the portfolio, while stocks with lower fundamental measures have a relatively lower
weight. For example, for a given stock universe, a strategy might use revenues
as a fundamental measure. The strategy’s creator could derive a weight for a
particular stock within the portfolio by taking the revenue for a particular stock
in the universe and dividing that figure by the sum total of revenues for all stocks
in the universe.
Smart beta strategies that focus on one or a small set of fundamental measures
can produce very concentrated portfolios that take significant (and sometimes
unintended) sector or factor bets. Fundamental indexing is sometimes referred
to as “value investing by another name” because portfolios constructed using a
limited set of fundamental measures often exhibit strong value characteristics.
Such an emphasis on a small set of fundamental measures can create greaterthan-expected risk for the portfolio. To compensate for this implicit value tilt,
some smart beta strategies seek to incorporate other fundamental measures
into the overall portfolio. For example, a smart beta portfolio might also incorporate
measures of earnings growth, earnings quality, volatility, or momentum—or a
combination thereof—in an attempt to gain exposure to a broader set of factors
and avoid the potential underperformance that a value tilt can produce in certain
market environments.
To illustrate this, consider the performance of momentum, volatility, value,
and growth over the last ten years, as shown in Figure 1. The chart shows global
returns for each of the above factors2 calculated using Barra’s GEM2L model.
For example, the return to momentum represents the return of a portfolio that
holds long positions in higher momentum stocks and short positions in lower
momentum stocks (momentum is measured by relative strength and historic
alpha) relative to a global index.
2 A brief description of the above factors may be found at msci.com.
BEYOND ACTIVE AND PASSIVE:
USING SMART BETA STRATEGIES // 5
The chart clearly shows that value delivers the highest return over the ten year period,
but its performance is flat during certain time periods (April 2007 – March 2009). It
also shows that momentum performs well from December 2003 until June 2008 but
then gives up almost all of its return over the following 15 months before recovering
over the following four years. In addition, the chart shows that returns to growth are
modest and that volatility has a negative return, including a comparatively sharp
drawdown during the culmination of the global financial crisis.
Figure 1: Returns for Selected Style Factors, Barra Global Equity Market Model
December 2003-December 2013, December 2003=100
140
Factor Returns
130
120
110
100
90
Dec-03
Apr-04
Aug-04
Dec-04
Apr-05
Aug-05
Dec-05
Apr-06
Aug-06
Dec-06
Apr-07
Aug-07
Dec-07
Apr-08
Aug-08
Dec-08
Apr-09
Aug-09
Dec-09
Apr-10
Aug-10
Dec-10
Apr-11
Aug-11
Dec-11
Apr-12
Aug-12
Dec-12
Apr-13
Aug-13
Dec-13
80
Value
Growth
Momentum
Volatility
Data Source: Barra
RISK-BASED STRATEGIES
The second type of smart beta strategies focus explicitly on risk. These include low
volatility, or minimum variance, strategies and maximum diversification strategies,
among others. Low volatility strategies are typically constructed to reduce or
minimize risk by emphasizing the volatility and correlation of all the assets in
the specified universe. Maximum diversification strategies seek to identify stocks
with the lowest correlation to one another. These strategies seek to improve
portfolio efficiency.
However, in seeking to minimize volatility or maximize diversification, these
strategies ignore fundamentals and therefore potentially expose the portfolio to
very different types of risk. For example, a low volatility approach selects stocks
that happen to have exhibited low historic volatility, even though this quite likely
leads to large and consistent sector biases. In addition, this approach ignores the
fact that, at times, low volatility stocks are exceedingly expensive relative both
to their own history and the rest of the market. On the other hand, a maximum
diversification approach may yield a portfolio that is dominated by high volatility
stocks that happen to have a low correlation with each other, likely leading to
relatively low overall portfolio volatility. This approach, too, is grounded more in
mathematical design than in economic logic.
A smart beta portfolio
might incorporate
measures of earnings
growth, earnings quality,
volatility, or momentum.
BEYOND ACTIVE AND PASSIVE:
USING SMART BETA STRATEGIES //
6
The table below summarizes the advantages of the two key types of equity
smart beta strategy and compares them to both traditional passive and
active management.
Figure 2: Comparison of Smart Beta, Passive and Active Management
Strategy
Mellon Capital believes
that investment returns
are predicated on economic
and financial fundamentals.
Advantages
Disadvantages
Traditional
Passive
Management
Cost-effective
Delivers equity risk
premium
Overweights more expensive stocks
Underweights less expensive stocks
Does not protect against downside risk
Traditional
Active
Management
Uses fundamental
insights
Has the potential to
deliver alpha
Relies to some extent on intuition and/or
complex optimization
FundamentalsBased
Smart Beta
Uses fundamental
insights
Has the potential to
deliver moderate
alpha
Cost-effective
Focus on single factor or factor group raises
risk or underperformance
Risk-Based
Smart Beta
Lowers volatility,
designed to mitigate
downside risk
Typically delivers equity
returns with higher
Sharpe Ratio
Takes significantly larger sector and risk factor bets
Relies on correlation forecasts and optimization
Utilizes statistical techniques rather than
fundamental insights
Data Source: Mellon Capital
MELLON CAPITAL’S APPROACH TO EQUITY SMART BETA STRATEGIES
Mellon Capital believes that investment returns are predicated on economic
and financial fundamentals. In partnership with clients and consultants, Mellon
Capital has been implementing customized smart beta strategies for a number
of years. Based on our investment philosophy and the custom beta strategies
that we have implemented for clients, we have developed a proprietary equity
smart beta framework that takes a “core” approach to portfolio construction,
anchored to a balanced set of investment rationales.
Rather than focusing on a single economic risk factor or narrow set of related
risk factors, we take a more balanced approach that draws on a range of different
risk premia derived from different factor groups and rely on economic and financial
analysis for stock selection and portfolio construction. Strategies that seek to
incorporate a number of different risk premia, as opposed to just one (or one
type) have a number of advantages. Using just one factor or set of similar
factors that represent a specific theme can lead to underperformance when
the risk of that particular factor is not compensated by its return. In contrast
to this approach, employing multiple factors from different factor groups such
as valuation, quality and momentum, has a diversification effect that offers a
more consistent stream of returns over time. Rather than weighting a smart
beta strategy based purely on economic factors such as sales and earnings
yields, adding a quality component (such as consistency of earnings and
earnings growth) will likely add additional risk-adjusted return.
BEYOND ACTIVE AND PASSIVE:
USING SMART BETA STRATEGIES // 7
Mellon Capital’s approach seeks efficient trade-offs between various
characteristics by balancing exposures to multiple factors while maintaining
a transparent investment framework, appropriate levels of risk management
and a moderate level of portfolio turnover. This multi-factor approach enables
us to retain a focus on the value-driven components of a stock’s price while
taking into account improving company fundamentals to avoid the “value trap.”
The inclusion of earnings quality in our process also provides some measure
of downside protection for the strategy since periods of higher risk and risk
aversion tend to encourage a flight to more defensive stocks that have higher
quality earnings.
Smart beta strategies offer investors some of the key benefits of traditional
passive portfolios–transparency, low cost, broad market exposure–while
adding customization and the potential for risk-adjusted excess returns.
BNY Mellon Investment Management is one of the world’s leading investment management organizations and one
of the top U.S. wealth managers, encompassing BNY Mellon’s affiliated investment management firms, wealth
management organization and global distribution companies. BNY Mellon is the corporate brand of The Bank of
New York Mellon Corporation and may also be used as a generic term to reference the Corporation as a whole or
its various subsidiaries generally.
The information in this document is not intended to be investment advice, and it may be deemed a financial
promotion in non-U.S. jurisdictions. Accordingly, where this document is used or distributed in any non-U.S.
jurisdiction, the information provided is for Professional Clients only. This material is not for onward distribution
to, or to be relied upon by, retail investors.
Any statements and opinions expressed in this document are as of the date of the article, are subject to change
as economic and market conditions dictate, and do not necessarily represent the views of BNY Mellon or any of
its affiliates. The information contained in this document has been provided as a general market commentary only
and does not constitute legal, tax, accounting, other professional counsel or investment advice, is not predictive
of future performance, and should not be construed as an offer to sell or a solicitation to buy any security or make
an offer where otherwise unlawful. The information has been provided without taking into account the investment
objective, financial situation or needs of any particular person. BNY Mellon and its affiliates are not responsible
for any subsequent investment advice given based on the information supplied. This document is not investment
research or a research recommendation for regulatory purposes as it does not constitute substantive research or
analysis. To the extent that these materials contain statements about future performance, such statements are
forward looking and are subject to a number of risks and uncertainties. Information and opinions presented in this
material have been obtained or derived from sources which BNY Mellon believed to be reliable, but BNY Mellon
makes no representation to its accuracy and completeness. BNY Mellon accepts no liability for loss arising from
use of this material. If nothing is indicated to the contrary, all figures are unaudited.
Any indication of past performance is not a guide to future performance. The value of investments can fall as well
as rise, so you may get back less than you originally invested.
This document is not intended for distribution to, or use by, any person or entity in any jurisdiction or country in
which such distribution or use would be contrary to local law or regulation. This document may not be distributed
or used for the purpose of offers or solicitations in any jurisdiction or in any circumstances in which such offers
or solicitations are unlawful or not authorized, or where there would be, by virtue of such distribution, new or
additional registration requirements. Persons into whose possession this document comes are required to
inform themselves about and to observe any restrictions that apply to the distribution of this document in
their jurisdiction. The investment products and services mentioned here are not insured by the FDIC (or any
other state or federal agency), are not deposits of or guaranteed by any bank, and may lose value.
This document should not be published in hard copy, electronic form, via the web or in any other medium
accessible to the public, unless authorized by BNY Mellon Investment Management.
Issuing entities
This document is approved for Global distribution and is issued in the following jurisdictions by the named local
entities or divisions: UK and in mainland Europe (excluding Germany): BNYMIM EMEA, BNY Mellon Centre, 160
Queen Victoria Street, London EC4V 4LA. Registered in England No. 1118580. Authorized and regulated by the
Financial Conduct Authority. • Germany: Meriten Investment Management GmbH which is regulated by the
Bundesanstalt für Finanzdienstleistungsaufsicht. • Dubai, United Arab Emirates: Dubai branch of The Bank
of New York Mellon, which is regulated by the Dubai Financial Services Authority. This material is intended
for Professional Clients only and no other person should act upon it. • Singapore: BNY Mellon Investment
Management Singapore Pte. Limited Co. Reg. 201230427E. Regulated by the Monetary Authority of Singapore. •
The Alcentra Group
Hong Kong: BNY Mellon Investment Management Hong Kong Limited. Regulated by the Hong Kong Securities and
ARX Investimentos Ltda
Futures Commission. • Japan: BNY Mellon Asset Management Japan Limited. BNY Mellon Asset Management
Japan Limited is a Financial Instruments Business Operator with license no 406 (Kinsho) at the Commissioner of
BNY Mellon Cash Investment Strategies
Kanto Local Finance Bureau and is a Member of the Investment Trusts Association, Japan and Japan Securities
BNY Mellon Western Fund Management
Investment Advisers Association. • Australia: BNY Mellon Investment Management Australia Ltd (ABN 56 102 482
Company Limited
815, AFS License No. 227865). Authorized and regulated by the Australian Securities & Investments Commission.
The Boston Company Asset Management, LLC
• United States: BNY Mellon Investment Management. • Canada: Securities are offered through BNY Mellon Asset
CenterSquare Investment Management, Inc.
Management Canada Ltd., registered as a Portfolio Manager and Exempt Market Dealer in all provinces and
CenterSquare Investment Management Holdings, Inc. territories of Canada, and as an Investment Fund Manager and Commodity Trading Manager in Ontario. • Brazil:
this document is issued by ARX Investimentos Ltda., Av. Borges de Medeiros, 633, 4th floor, Rio de Janeiro, RJ,
The Dreyfus Corporation
Brazil, CEP 22430-041. Authorized and regulated by the Brazilian Securities and Exchange Commission (CVM).
EACM Advisors LLC
Hamon Investment Group
Insight Investment
Mellon Capital Management Corporation
Meriten Investment Management
The Newton Group
Siguler Guff & Company LP
Standish Mellon Asset Management Company LLC
Walter Scott & Partners Limited
The issuing entities above are BNY Mellon entities ultimately owned by The Bank of New York Mellon Corporation
©2014 The Bank of New York Mellon Corporation. 9/14
BNY Mellon Company information
BNY Mellon Cash Investment Strategies is a division of The Dreyfus Corporation. • BNY Mellon Western FMC,
Insight Investment Management Limited and Meriten Investment Management GmbH do not offer services in the
U.S. This presentation does not constitute an offer to sell, or a solicitation of an offer to purchase, any of the firms’
services or funds to any U.S. investor, or where otherwise unlawful. • BNY Mellon Western Fund Management
Company Limited is a joint venture between BNY Mellon (49%) and China based Western Securities Company Ltd.
(51%). The firm does not offer services outside of the People’s Republic of China. • BNY Mellon owns 90% of The
Boston Company Asset Management, LLC and the remainder is owned by employees of the firm. • BNY Mellon
owns a 19.9% minority interest in The Hamon Investment Group Pte Limited, the parent company of Blackfriars
Asset Management Limited and Hamon Asian Advisors Limited both of which offer investment services in the
U.S. • The Newton Group (“Newton”) is comprised of the following affiliated companies: Newton Investment
Management Limited, Newton Capital Management Limited (NCM Ltd), Newton Capital Management LLC (NCM
LLC), Newton International Investment Management Limited and Newton Fund Managers (C.I.) Limited. NCM LLC
personnel are supervised persons of NCM Ltd and NCM LLC does not provide investment advice, all of which is
conducted by NCM Ltd. Only NCM LLC and NCM Ltd offer services in the U.S. • BNY Mellon owns a 20% interest
in Siguler Guff & Company, LP and certain related entities (including Siguler Guff Advisers LLC).
bnymellonim.com