22. Smart-Beta Strategy

Published at 1664206944.582403


Smart-beta strategy , or factor investing, is a strategy for building a portfolio according to a system. It’s based on rules, and the use of fundamental business factors, e.g. liquidity, value, and quality, as criteria for making investment decisions.

Smart beta is the scaling strategy of the passive investment strategy. With passive investing, investors only need to buy the entire component shares of an index as a proportion of market capitalization. They hold for the long term to achieve returns comparable to the reference index. With smart beta, the portfolio weights are determined based on fundamental factors rather than market capitalization. The goal is to increase the proportion of stocks with high return potential, and in contrast, reduce the proportion of less potential stocks. It optimizes the portfolio with better returns compared to  investment strategies.

Theoretically, smart beta combines components of both passive and active investment.

Example of Smart Beta 

An investor believes that over the long term, stocks with low P/E tend to generate higher returns than the overall market average. Applying this investment perspective by taking VN-Index as a benchmark, this investor builds a portfolio according to the Beta strategy as follows: buy all VN-Index shares and hold for the long term. The weights are determined according to the rules: the lower the P/E, the higher the weight.

As an illustration, assume VN-Index has only 5 component stocks A, B, C, D, and E. Investors use P/E as a parameter to calculate the portfolio weight as shown in the table below:


This strategy is quite similar to passive investing, but the P/E ratio is used to determine portfolio weights, instead of market capitalization.

In the same instance, investors can determine portfolio weights using other methods, as long as the first principle is maintained: “Increase the weights of stocks with low P/E and reduce the weights of stocks with high P/E.” Below are some prime examples.

  • Only invest in x stocks in VN-Index with the lowest P/E, also known as shortlisting. For example, suppose VN-Index has 500 stocks, invest in only the bottom 50 stocks with the lowest P/E. The proportion is 2% for each shortlisted stock and none for others.

  • Determine an acceptable threshold of the P/E and only buy stocks satisfying this constraint.

Some Commonly Used Factors in Smart Beta Strategy

In investing, a “factor” is understood as a variable or characteristic highly correlated with stock returns. The factor can also be defined broadly as any variable that investors believe is valuable in ranking stocks and predicting future returns and risks. Below are 5 commonly used and widely accepted factors.

  • Value. In the long run, investing in stocks undervalued by the market has a higher rate of return than overvalued stocks. The value factor can be measured from key metrics in corporate financial statements, such as P/E ratio, dividends, income, cash flow, EBIT, and EBITDA.
  • Market capitalization. Small-cap stocks tend to rise more sharply than large-cap stocks.
  • Volatility. Increasing the weights of low-risk stocks can help improve the portfolio’s return on risk.
  • Quality. High-quality companies will increase the share price over time to reflect their intrinsic value. Some basic criteria of high quality are strong, stable profitability, and low leverage ratio.
  • Momentum. Recently rising stocks tend to continue gaining similar momentum in the short term.

In reality, there are hundreds of factors that have been identified and used in building portfolios under smart beta. Additionally, investors can combine them to create more variations of this strategy.

Strengths and Weaknesses

Combining active and passive investing, the smart-beta strategy has several advantages of passive investing such as transparency, transaction costs, and low monitoring costs. At the same time, smart beta also shares advantages of active investing like a higher potential return than average, and diversified investment depending on the preference and domain knowledge of each investor.

However, identifying key factors and rules in smart-beta strategy can be complex. It requires skills in testing historical data and experience plus in-depth knowledge of financial analysis. Besides, these factors often come from corporate financial statement data. In the Vietnamese market, it can be a huge hurdle to gather detailed, complete, and accurate financial statements of all listed companies. It remains the main challenge for investors following this strategy.

Application in Algorithmic Trading in Vietnam

With an algorithmic trading system , computing the financial factors of all stocks in the market has become simpler than ever. Besides common metrics like P/E, P/B, and ROE, investors can freely customize further metrics as desired. An example is the short-term unrealized revenue divided by the total revenue of the last 4 quarters. It reflects the percentage of potential revenue recorded in the next 4 quarters. Under the same conditions, the higher this factor is, the more stable and solid the company is.

An algorithm following a smart-beta strategy can include many of the customized metrics like those above. They can be adjusted to different weights as the portfolio desires.

Note that it’s key to restrict frequent portfolio restructuring and aggressive trading. It’s to ensure the passive investing components of the portfolio.