But, Is It The Smartest Beta?

It seems that Smart Beta strategies are all the rage these days. What used to be alpha factors (momentum, size, quality, low-vol, etc.) are now being isolated as smart beta factors leading to indexes being reweighted to take advantage of these exposures. But, in reweighting the index exposures are they not engaging in active strategies? One should be asking if these factor exposures always outperform, and of course, the answer is an unequivocal NO! Furthermore, what is the capacity of some of these exposures?

If one wants to truly engage in a beta exercise, shouldn’t they identify the “smartest beta” portfolio, which is the portfolio that best matches and achieves the true client objective with the least amount of risk and cost? Risk is best measured as the uncertainty of achieving the objective. Cost is the amount required to fund the objective. The true objective of most institutions and even individuals is some type of liability (annuities, banks, insurance, lotteries, NDT, OPEB, pensions, etc.). The absolute level of volatility of returns is not risk given a liability objective.

The most appropriate and smartest beta portfolio is the one that matches the liabilities cash flow.  In essence, the smartest beta portfolio is a custom liability index fund. Such a portfolio should be the core portfolio for any liability objective.  By matching the liability term structure the uncertainty of matching liabilities is eliminated and interest rate sensitivity is neutralized. By matching the liability term structure with bonds that have higher yields and lower present values (price) than the discount rates used will lead to cost savings. Since the accounting rules (ASC 715, IASB, and PPA) use AA zero-coupon discount rates then a liability beta portfolio of As and BBBs will produce higher yields and lower costs that will lead to cost savings of approximately 10% to 15%. Thus, the smartest beta portfolio is a liability cash flow matched portfolio!


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