DR.CHENJIAZI ZHONG

Institutional investors have employed alternative weighting and factor-driven strategies for decades. In recent years, a growing variety of alternative beta strategies have come to market, as investment managers are pursuing alternative opportunities in face of the sharp fall in the share of active management relative to passive investing. These beta strategies have become a fairly elastic concept that is used to stretch around many different strategies. Among all, the most fashionable beta strategies are:

• Alternative beta or smart beta refers to the risk premium which are beyond that triggered by long-only traditional equity or fixed income investments, and it generally outperforms market-cap-weighted benchmarks. Smart beta in its most ideal form is simple in structure and transparent in its source of value added, having a balance in risk against return, and keeping implementation costs low. It can be value investing, momentum investing, carry investing, to name a few, and it applies to multiple asset classes. For instance, a standard smart beta strategy should deliver a fully-rebalanced return without a significant tilt to small companies, and avoid costly and unnecessary turnover. Smart beta strategies often disclose a list of rules used to construct and reorganize the investments. Data from Towers Watson show that smart beta strategies have outperformed the market-cap strategies by 0.9% to 2.1%, on average, since 1964. Institutional investors allocated three times as many assets to smart-beta strategies in 2013, compared with the previous year.
• Scientific beta is a new approach to smart beta. It was invented initially to address three basic principles: greater choices, transparency, and clarity or detailed performance and risk analytics.
• Liquid alternative beta strategies, such as event-driven, managed futures, and merger arbitrage, aim to replicate aggregate return profiles of broad hedge fund universe utilizing liquid instruments. Managed futures could be well positioned to benefit from trends across asset classes, while merger arbitrage would benefit from a favorable economic environment and excess cash on balance sheets.
• Exotic beta refers to investments in “exotic” assets such as aircraft leasing, freight rates, insurance-linked securities, or “normal” strategies with new trading styles to seek arbitrage in markets, although the definition of exotic beta means different to different investors.

The risks associated with smart-beta strategies can be filed in two categories:

• Systematic risks: New benchmarks can be more or less exposed to particular risk factors depending on the methodological choices guiding the construction of smart-beta strategy or the construction quality of the benchmark.
• Specific risks: Specific risks rely on modeling assumptions and parameter estimation. Imposing some structure to the statistical problem can alleviate the reliance on pure sample-based information to some extent.

How to Choose from Beta Strategies?

Beta is the return generated from a portfolio that can be attributed to overall market returns and systematic risk. The basic ways to obtain beta exposure are to buy an index fund, buy a futures contract, or buy some combination of the two. Smart-beta strategies may provide better risk-adjusted returns by allowing investors to capture premia from various risk factors such as value, small- cap, momentum and low volatility.

Investors should note that the most efficient beta strategies in essence are featured by:

1. Rules-based and transparent
2. Diversified and with high capacity exposure
3. Low tracking error
4. Low turnover
5. Best execution of trades
6. Greater expected risk-adjusted returns than market-cap-weighted indices

The “smartest” beta-strategy investment managers in the industry have the capability and flexibility to implement customized solutions to their clients in different market segments through a big spectrum of global index products. For individual investors, another benefit of smart-beta products is that some of them can focus on tax-efficiency, and provide customized returns depending on one’s investment objectives as well.