The Case for Investing in Smart Beta

In the fluctuating world of financial markets, investors are constantly seeking strategies that would allow them to outperform market indices while minimizing risks. Making the most of such contradictory desires can be challenging!

Among the emerging approaches, smart beta stands out as an innovative strategy aiming at optimizing the risk-return ratio.

Let’s take 3 minutes to understand the potential of this approach designed for modern investors:

Passive vs. Active Management

Diversification is the basics of long-term investment. As markets are confronted to daily ups and downs, stock picking can be risky: you would rather allocate your savings in several assets and keep your investment a certain amount of time to reduce risks of capital loss. John Bogle invented the 60/40 portfolio – 60% being invested in bonds, 40% in stocks – in the earlier 20’s, which was a first example of what we now call passive management.

Passive management, often represented by index funds and ETFs, relies on replicating the performance of a market index, ensuring low fees and higher predictability. The main goal is not to beat the index but to replicate its performance. For instance, the investor that buys an S&P500 tracking ETF would benefit from same returns as the main American market index (S&P), minus very low management fees. The idea here is not to outperform the market but rather buying and holding assets following benchmark trends, while reducing risks and minimizing efforts.

In contrast, active management aims to beat market returns through careful asset selection – often based on fundamental value analysis – and strategic weighting.  An active manager seeks to achieve higher returns by selecting "winning" stocks or timing the market. Although potentially more lucrative, active management also involves higher fees and increased risk.

Drawbacks of passive and active managements

However, both kinds of management are facing disadvantages.

Passive management, while praised for its simplicity and low cost, suffers several notable drawbacks:

• Firstly, by strictly following an index, passive investments inherently accept average market returns, sacrificing the potential to outperform the market.

• Furthermore, passive management lacks flexibility. It does not allow for strategic shifts based on changing economic or market conditions, which can be a critical disadvantage during financial crises or when certain sectors are significantly underperforming.

Hence, passive management can be particularly frustrating during market downturns, as passive strategies offer no protection against losses. They merely reflect the market's overall performance.

Active management, on the other hand, comes with its own set of challenges:

• The primary drawback is the higher cost. Active funds typically charge higher management fees - up to 2% of asset under management annually - to cover the expenses of research and active trading. These costs can significantly eat into any extra returns generated by active strategies.

• Additionally, it relies heavily on the skill of the fund manager. While some managers may achieve superior returns, the majority struggle to consistently outperform their benchmarks, especially after accounting for fees. This could end up for the average investor in a riskier and sometimes underperforming portfolio.

• The active approach also involves higher transaction costs due to frequent buying and selling of securities, which can further diminish net returns.

Here comes Smart beta, an emerging kind of investment strategies trying to combine best dimensions of both passive and active managements.

Introduction to Smart Beta: best of both worlds

Smart Beta investment strategy lies at the intersection of passive and active management. It employs fixed but sophisticated rules (which is a passive dimension) to rebalance and weight the portfolio according to specific risk factors (which is more active), such as volatility, momentum, quality, size, and value, aiming to capture superior returns.

Hence a Smart Beta strategy combines quality of passive and active management:

• It shows ability to diversify risks more effectively than traditional passive management, by avoiding excessive concentration on certain stocks or sectors.

• By targeting specific factors, smart beta can also generate higher risk-adjusted returns, thus offering better overall performance compared to conventional indices, which is a typical goal of active strategies.

This risk-reward optimization has driven the increasing popularity of Smart Beta portfolios in today’s investors’ decisions. The weight of Exchange Traded Funds (ETF), that track specific indexes or risk factors, is often significative in the composition of such portfolios.

This improved risk-reward balance is also why Workka is committed to provide Smart Beta portfolios to the average investor. We believe that efficient and performing strategies shall be available to everybody, not the private hunting ground of the 0,01%.

Where does the market stand today

Historically, passive management began to take off in the 1970s, gradually gaining favor among institutional and private investors. From the invention of Exchange Traded Funds (ETF) in the early 90’s, ETFs & passive management market share has continuously increased. Such allocations became even more reputable with successful fund managers releasing passive portfolios, like Ray Dalio’s All season for instance.

As of today, half of assets are now under passive management in the USA, including + € 6 780 bln € invested in ETFs. In Europe, this trend has lagged behind for a long time but it is expected to rapidly bridge the gap in the coming years: AUM of passive management has multiplied by 3.5 in the last 10 years, including ETF market reaching € 1720 bln in 2023.

This trend has been supported by the large democratization of the access to financial markets led by neo-brokers, like RobinHood in the United States or Degiro in Europe.

We believe average investors now need a further step of democratization based on digital players empowering them to make the most of their financial investments with sound strategies and advice.

Conclusion

To sum up, Smart beta represents a significant advancement in the field of investment, offering an ideal intermediary solution for those aiming for a better balance between risk and return, while seeking simplicity of passive management and potential performances associated with active management alike.

To discover how smart beta can help you achieve your financial goals with a tailored strategy, explore our platform: you’ll find smart portfolios designed to maximize your potential for risk-adjusted return.

Last but not least: What about powering smart portfolios with Artificial Intelligence? Well, that’s the next Frontier 😊😊

Interestd? Answer survey ➡️https://tally.so/r/3EXexr

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Reminder: Investors need to carefully consider their own financial goals, risk tolerance, and investment horizon when choosing an investment strategy. Each approach has its merits and limitations, and what works best for one investor might not be suitable for another.

This is why Workka is dedicated to build a Wealth copilot that will help you assess your profile risk and choose the best automatic portfolio accordingly.