Concentration Problems

Smart beta and its hidden risks

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sheepSmart beta presents a beguiling prospect to investors: a set-and-forget investment approach that can regularly outperform market-capitalization-based indices. But, there are hidden risks. Specifically, smart beta automates the investment process through the investment cycle and only considers specific characteristics. Such a robotic response to the investment cycle can result in concentrations in the portfolio, and sudden and dramatic changes in investment themes on rebalance dates. This type of response to changing market conditions neglects the important role portfolio management plays in constructing efficient portfolio.

Portfolio management is about skilful portfolio construction, efficient implementation and good risk management. These skills cannot be outsourced to transparent, rules-based approaches that automate the responses to the market with minimal (or no) human oversight. By marketing smart beta as an index-like product, investors may think that they don’t need to apply the same due diligence that they would for an active manager. Unfortunately, this opinion may be misguided, as automated rules could lead to a buildup of unexpected risks in portfolios. That could result in outcomes that the investor may not expect.

Concentration problems

What types of concentration issues can be seen in smart beta products? One issue is that minimum volatility strategies have a tendency to converge on low volatility sectors or countries, but that low volatility in a company, sector or country may turn out to be a transitory attribute or a poor reflection of underlying strength. For example, many financial stocks exhibited low volatility prior to the global financial crisis, but analysis of their fundamentals highlighted real underlying risks in the form of excessive leverage and elevated funding pressures. Such a strategy is, therefore, only likely to perform well in certain market conditions. It can also lead to buying or selling in areas of the market just when it is most inappropriate for a defensive strategy.

An additional concern with automated processes like smart beta is there is no human navigating the portfolio through the investment cycle. This may mean sudden and dramatic changes in portfolio characteristics at the rebalancing dates, radically altering the portfolio’s investment themes. None of this would be considered acceptable in an actively managed strategy. Rapid changes in asset allocation can dramatically change the characteristics and drivers of a portfolio’s performance while ignoring the changing nature of risk through the investment cycle.

Accordingly, investors should closely monitor smart beta products to ensure the risks they are taking are appropriate, and that they maintain positions that match their expectations.

The art of portfolio management is about skilful portfolio construction, efficient implementation, and good risk management. Neglecting these issues through a set-and-forget, rules-based strategy may increase investment risk by ignoring the changing nature of risk through the investment cycle. Investors should overcome these limitations by overlaying highly diversified portfolios with an active stock selection focused on company fundamentals designed to highlight value and quality. The goal of such an approach is improved consistency through the investment cycle.

Michael O’Brien, Ph.D., is analyst and fund manager, Schroders

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