Asset AllocationApril 24, 2016

How to Build Smart Beta 2.0

Tilting an already tilted portfolio can result in higher active share as well as better factor combinations, according to Morningstar.

Reported by Featured Author

Concentrated or “targeted” smart beta funds will be the next wave of indexing, according to Morningstar’s Vice President of Research John Rekenthaler.

“Targeting can be thought of as tilting, tilted again.”Just as smart beta strategies sought to replace replicating indexes by “tilting” to a certain factor, targeted funds with conviction are likely to deliver outperformance and appeal to investors who value “indexing’s virtues,” the columnist wrote.

“Targeting can be thought of as tilting, tilted again,” Rekenthaler continued. “[It] can be considered as hyperactive management, implemented mechanically.”

According to the column, tilting significantly reduces the number of stocks considered for a portfolio, but also retains hundreds.

“Tilting is a strategy that comes from the academic community, based on the research of comprehensive databases, ad is intended to be applied very broadly,” Rekenthaler wrote. “Professors are cautious. When professors play the odds, they want the law of large numbers on their side.”

And this idea has been successful. Smart beta funds make up 12% of indexed mutual and exchange-traded funds, representing half a trillion dollars in assets.

“Tilting has moved well beyond cult status,” the columnist said. “The approach is here to stay.”

However, taking smart beta and applying investment managers’ conviction would result in a more concentrated portfolio of stocks—as few as 50.

Referencing investment manager Patrick O’Shaughnessy, Rekenthaler explained target indexes begin with zero in each stock, not with the market weight. This would likely result in higher active share as well as potential for alpha.

This targeted approach would result in the best possible factor combinations for outperformance, as well as lower expense ratios than traditionally managed indexes, he added.

“Targeted funds will be made for the times,” Rekenthaler concluded. “I think it will become an established method by which funds invest.”