Discover The Science Of Smart Investing With Smart Alpha

Discover The Science Of Smart Investing With Smart Alpha


It is notoriously difficult to predict movements in financial markets with any degree of accuracy. In fact, no one can predict with any statistical significance how the price of any financial instrument will behave over a given future time-frame.

In many ways, the prediction of movements in financial markets is similar to another time-series system that is notoriously difficult to predict: The weather. However, there is more predictability in weather patterns, due to seasonal certainty, compared to financial markets where there is very little certainty in what will happen tomorrow, never mind in a year’s time.

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The difficulty in predicting returns leads to some puzzling issues in modern empirical finance, especially since many of these modern processes rely on assumptions of future returns. Most notably, asset allocation is a process that distributes funds to different asset classes based on the long term returns the asset classes generate above a defined risk-free asset (in most cases the prevailing cash return and sometimes a rate of inflation).

In the aftermath of the 2008 financial crisis, a large pension fund turned to several of the best minds in academia in an attempt to uncover why they had suffered such severe losses. They contracted with Andrew Ang (Columbia Business School), William Goetzmann (Yale) and Stephen Schaefer (London Business School)*, who produced a journal paper on the fund which, as one may imagine, is somewhat technical and includes an extensive review on the Efficient Market Hypothesis. However, one of the key conclusions they reached is that even though the fund was well diversified across asset classes and invested with around 70 of the world’s top money managers; it was not diversified from a risk perspective.

The underlying managers were taking similar types of risks and exposing the fund, on an aggregate level, to large bets on certain risk factors which came under significant pressure during the financial crisis.

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This leads to some critical thinking around the returns generated by managers and what risks are being taken with investors’ assets.

Most asset managers are intent on outperforming a specific benchmark, and they do this by utilising a predefined investment process, often referred to as the asset manager’s style.

A good example of style, ubiquitous in the equity market, is the Value philosophy which was conceptualised and formalised largely by Benjamin Graham and made famous by Warren Buffet. Most academics and market practitioners agree that value strategies outperform market capitalisation weighted indices over time.

The critical question is whether or not managers running Value styles are able to outperform, due to skill or simply because they are taking a different set of risks in their portfolios when compared to accepted market benchmarks. This, in some sense, makes the active versus passive investment debate somewhat blurred, as suddenly one may not be able to compare them reliably since they are arguably different from a risk perspective.

So much so that many consultants in the international market are now comparing active managers with benchmarks that are more representative of the risks that the managers are taking; leading to the emergence of the Smart Beta industry. Smart Beta indices utilise specific risk or fundamental factors in their construction process, and deviate from the pure market capitalisation weighted approach that is traditionally utilised in the industry.

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7193T_Absa_SmartAlpha_3rdParty_300x300Although returns themselves are extremely difficult to predict, it seems that by allocating to differentiated risks, one is able to generate a statistically significant excess return or “Alpha”, over market capitalisation weighted indices.

Curiously, there are several styles that lead to an excess return expectation. Therefore portfolios should be constructed in such a way that they are weighted across diverse risk factors, as allocating solely to any one risk factor, no matter how diverse the number of managers, may lead to significant losses in asset value, due to risk concentration.

St John Bunkell, from Absa Alternative Asset Management believes that it is possible to enhance “Smart Beta investing” further by constructing portfolios that target Alpha over Smart Beta indices.

This is achieved by allocating to diverse risk styles, specifically utilising value and momentum strategies which he sees as two of the strongest empirical regularities in finance. He further asserts that, although there seems to be very little ability to predict Beta (general market risks and returns), there is some predictability in Alpha (relative return of stocks against indices).

Combining these two strong excess return drivers (value and momentum) within a very specific risk framework, as well as utilising fundamental and mathematical definitions of value and momentum, the Absa Alternative Asset Management team has created a unique fund range, referred to as the “Smart Alpha” fund range. The most critical component of these funds is to ensure that they continuously take the correct level of risk for the investor, as too much or too little risk may have detrimental consequences.

The investment strategies utilised in these new unit trust finds were previously only available to institutional investors, but are now available to the retail market.

If you are interested in these Unit Trusts or have any enquiries, please call 0860 111 456 or email

Strive for the exceptional. Prosper.


*Andrew Ang, William N. Goetzmann and Stephen M. Schaefer, Evaluation of Active Management of the Norwegian Government Pension Fund – Global, December 14, 2009

Absa Bank Limited (Absa Bank), with preference shares listed on the JSE Limited, is a wholly-owned subsidiary of the Barclays Africa Group. We offer a range of retail, business, corporate and investment banking, and wealth management products and services primarily in South Africa and Namibia.

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