Beyond Active and Passive:

Using Smart Beta Strategies

to Build More Efficient
Portfolios
September 2014

EXECUTIVE SUMMARY
Smart beta strategies can be thought of as a form 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
By William Cazalet, CAIA smart beta strategies may be desirable complements to both
Managing Director passive strategies that track market capitalization-weighted
Global Investment Strategist
Mellon Capital Management
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
Smart beta strategies to compensate for at least some of the biases of market
may be desirable capitalization-weighting by overweighting stocks with attractive
complements to both fundamental characteristics that have the potential to deliver
passive strategies an excess return. They believe the power of smart beta
and conventional strategies lies in its ability to combine the more favorable
active strategies. 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

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 earnings strength factors. Including
Smart beta strategies
these factors delivers a more “core” smart beta strategy that
deliver beta exposure
in a cost-effective and offers downside risk management, while retaining the original
transparent manner. 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 return
premiums (sometimes referred to as 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 cost-
effective 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.

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 lower-
cost 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.

1 Other terms may include scientific beta, strategic beta, fundamental indexing, custom beta, systematic
beta, and advanced beta.
 BEYOND ACTIVE AND PASSIVE:
USING SMART BETA STRATEGIES // 3

THE ORIGIN AND CHARACTERISTICS OF SMART BETA

Smart beta derives from the realization that return premiums 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 connections between an asset’s Investors should view
price and its weight in a specific benchmark. smart beta strategies as
more transparent forms of
Market capitalization-weighted portfolios, especially those based on larger
capitalization stocks (i.e. the S&P 500®), are also overweight in so-called active management.
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.
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 FUNDAMENTALS-BASED STRATEGIES
in order to construct 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
a portfolio. 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 greater-
than-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 10 years, as shown in Figure 1. The chart shows global returns
for each of the above factors calculated using Barra’s Global Equity Model (GEM2L).
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, such as the MSCI World Index.
 BEYOND ACTIVE AND PASSIVE:
USING SMART BETA STRATEGIES // 5

The chart clearly shows that value delivers the highest return over the 10 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.
A smart beta portfolio
Figure 1: Returns for Selected Style Factors, Barra Global Equity Market Model might incorporate
December 2003-December 2013, December 2003=100 measures of earnings
growth, earnings quality,
140
volatility, or momentum.
130

120
Factor Returns

110

100

90

80
Dec-11
Aug-11
Apr-04

Apr-05

Apr-06

Apr-07

Apr-08

Apr-09

Apr-10

Apr-11

Apr-12

Apr-13
Dec-03

Dec-04

Dec-05

Dec-06

Dec-07

Dec-08

Dec-09

Dec-10

Dec-12

Dec-13
Aug-04

Aug-05

Aug-06

Aug-07

Aug-08

Aug-09

Aug-10

Aug-12

Aug-13

Value Growth Momentum Volatility

Data Source: Barra, December 2013. Past performance is no guarantee of future results.
Investors cannot invest directly in any index. Please refer to page 7 for information on the style
factor indexes shown above.

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.
BEYOND ACTIVE AND PASSIVE:
USING SMART BETA STRATEGIES // 6

The table below summarizes what we view to be 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 Advantages Disadvantages

Traditional Cost-effective Overweights more expensive stocks

A second type of smart Passive Delivers equity risk Underweights less expensive stocks
Management
beta strategies focus premium Does not protect against downside risk

explicitly on risk. Traditional Uses fundamental Relies to some extent on intuition and/or
Active insights complex optimization
Management Has the potential to Higher fees, generally
deliver alpha

Fundamentals- Uses fundamental Focus on single factor or factor group raises

Based insights risk of underperformance
Smart Beta Has the potential to
deliver moderate
alpha
Cost-effective

Risk-Based Lowers volatility, Takes significantly larger sector and risk factor bets
Smart Beta designed to mitigate Relies on correlation forecasts and optimization
downside risk Utilizes statistical techniques rather than
Typically delivers equity fundamental insights
returns with higher
Sharpe Ratio

Source: Mellon Capital. There can be no guarantee that any investment objective will be
successful. All investment involves risk, including the risk of loss of principal.

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
return premiums 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 return premiums, 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 earnings strength, 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 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. Strategies that seek to
incorporate a variety of
Smart beta strategies offer investors some of the key benefits of traditional
passive portfolios–transparency, low cost, broad market exposure–while adding
return premiums, as opposed
customization and the potential for risk-adjusted excess returns. to just one (or one type) have
a number of advantages.

Definitions
Correlation measures the degree to which the performance of a given asset class
moves in relation to another, on a scale of –1 to 1. Negative 1 indicates a perfectly
inverse relationship, 0 indicates no relationship and 1 indicates a perfectly
positive relationship.
Value factor captures excess returns to stocks that have low prices relative to
their fundamental value as measured by the MSCI Value Weighted Indexes.
Momentum factor reflects excess returns to stocks with stronger past
performance (generally measured by relative returns as measured by the MSCI
Momentum Indexes.
Volatility factor captures excess returns to stocks with lower than average
volatility, beta, and/or idiosyncratic risk as measured by the MSCI Minimum
Volatility Indexes.
Growth factor captures excess returns to stocks that are characterized by low
debt, stable earnings growth, and other “quality” metrics generally measured by
the MSCI Quality Indexes.
The Morgan Stanley Capital International (MSCI) World Index is an unmanaged
total return index of global stock market performance consisting solely of equity
securities.
The Standard & Poor’s 500 Composite Stock Price Index is a widely accepted,
unmanaged total return index of U.S. stock market performance.
Each of the indices listed are a trademarks of the foregoing licenser and are
used herein solely for comparative purposes. The foregoing index licenser does
not sponsor, endorse, sell or promote the investment strategies or products
mentioned in this paper, and makes no representation regarding the advisability
of investing in the products or strategies described herein. Investors cannot
invest directly in any index, the returns of which will vary from that of a mutual
fund due to the absence of fees and expenses.
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