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Private Asset Management Magazine – Brandon Thomas, co-founder and chief investment officer of Envestnet|PMC, gives the lowdown on utilizing smart beta products.

Q: Why are investors choosing ‘smart beta’ products?

A: Although the term ‘smart beta’ has become widely used in the industry, it really is a misnomer. When the sponsors or managers of a product disengage from a passive market-cap weighted approach, it is no longer a beta strategy. Rather, it is an active strategy that strives to outperform passive beta strategies and indexes. ‘Smart beta’ is a marketing label applied to a subset of products that follow a systematic quantitative approach.

With that backdrop, the uptick in so-called ‘smart beta’ and similar strategic investments has two drivers. Firstly, advisors and investors are increasingly disillusioned with traditional active managers, who charge high fees but have failed to outperform benchmarks over time, particularly over the past five to six years. Secondly, since the financial crisis of 2008-2009, focus has shifted to the tremendous amount of research conducted over the past 30 years on factor-tilted portfolios. These portfolios use certain asset-pricing anomalies to generate excess returns over time. Smart beta and other systematic quantitative strategies are viable options for clients who want to beat the market, but lack conviction in active stock pickers.

Q: How can family offices and advisors use smart beta products to grow business?

A: Most high-net-worth investors stay with their advisors until death or disaster, so the best way multifamily offices and advisory teams can win more clients is by beefing up their value propositions. Offering access to systematic quantitative products is one way they can demonstrate more value, because these strategies are designed to provide excess returns over the long term. In addition, even though these strategies have characteristics of active management, they offer investors the possibility of achieving excess returns without paying the higher fees associated with active managers. Advisors will be rewarded with new and lasting client relationships if they can achieve outperformance in exchange for lower fees, especially in flat markets, where every basis point counts.

Q: Which smart beta strategies function best within portfolios?

A: The theme among most ‘smart beta’ strategies is capturing average excess returns associated with some characteristic factor common to all stocks. For example, strategies that simply equal-weight an index’s constituents attempt to capture the small-cap premium. Fundamental indexing strategies capture the value premium by overweighting stocks with low price multiples, such as price/earnings or price/book value. Because of their varying factor exposures, these products behave differently. Advisors and family offices need to understand the underlying factor orientations of each product in order to identify the strategies best-suited for their clients.

Q: Are there certain factor exposures which rise to the top?

A: Researchers have examined many factors that influence stock prices and portfolio returns, but only a handful demonstrate an ability to produce excess returns over long time periods. Size and value are two of the most well-known. We favor proven factors with low historical correlations, because they generally do well on a standalone basis and, in combination, can improve risk-adjusted returns significantly.

For example, the factor-enhanced portfolios, a series of quantitative portfolios that we manage, combine two robust drivers of long-term excess returns—momentum and value. We chose them because they not only are strong independently, but also are negatively correlated and, therefore, tend to offset each other. In the mid-1990s, momentum did very well at a time when headlines were screaming, ‘Is value investing dead?’ However, in 2009, when we were coming out of a downturn, momentum suffered as value surged.

Q: How can advisors customize smart beta strategies for investors, especially for those concerned about minimizing tax liabilities?

A: Advisors can tailor smart beta products for their clients by investing in strategies available through separately managed accounts, which provide more investor-friendly access to beneficial factor exposures than ETFs.

A separately managed account offers the control and customization found in actively managed products. Its structure allows advisors to meet their clients’ individual objectives by, for example, applying impact investing screens to accommodate investment preferences, or employing active tax management to mitigate tax liabilities. Taxes are often the largest contributor to portfolio losses, but active tax management can return as much as 60 basis points in annual portfolio value that an investor would have paid in taxes.

This article originally appeared on Private Asset Management Magazine.

Featuring

Brandon Thomas
Chief Investment Officer

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