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Smart Beta as a trend

Smart Beta – invest intelligently Traditional indices are capitalization weighted, i.e. the weight of a stock constituting the index is determined by its market value. The concept Smart Beta (or: Optimized Indexing) refers to all alternative weighting methods which reflect the market risk (the so-called Beta) in a more intelligent way than classical indices.

Smart Beta gains in importance It is estimated that over 150 billion dollars are invested in Smart Beta assets worldwide, where the assets under management in Europe have been increased by a factor of eight during the last 3 years.

Why Smart Beta? The academic research indicates the inefficiency and construction deficits of capitalization weighted indices for a long time. Smart Beta means to construct an index in an alternative way with the target to achieve more return for the taken risk.

With its established IsoPro®-methodology, Finreon is one of the leading Smart Beta provider in Switzerland.

 

IsoPro®-methodology
IsoPro®-methodology

Passive indices suffer from structural deficits

Passive index funds seek to replicate an index as close as possible. This kind of index construction, however, carries some significant problems. Most of the large indices, such as the Swiss Performance Index SPI, the German equity index DAX or the American equity index S&P 500 are capitalisation weighted, i.e. the weight of every single stock constituting the index is calculated based on its market value. Therefore, many indices struggle with concentration risks: The five largest positions of the Swiss Performance Index add up to more than 60 % of the total index' market capitalization. Additionally, capitalisation weighted indices are by definition constantly overweighted in overvalued stocks while undervalued stocks are underweighted (so called ‘passive noise’). Finally, indices are also inefficient as the correlations among the index constituents and their volatilities are ignored in portfolio construction.

These structural deficits of indices are systematically eliminated by employing the IsoPro®-methodology, which seeks to generate higher relative returns and to minimize the risks.

 

Weights of stocks in the Swiss Performance Index SPI (illustrative)
Weights of stocks in the Swiss Performance Index SPI (illustrative)

The Solution: The IsoPro® investment methodology

The innovative IsoPro®-methodology was developed by Finreon and allows to benefit from passive investments while avoiding their shortcomings. In a first step, the IsoPro®– methodology is based on equal weighting (Iso), i.e. the same weight is allocated to every index, provided there are no liquidity issues. By this means, both concentration risks and passive noise (overweight overvalued and underweight undervalued stocks) can be reduced. In a second step, the weights are optimized towards the minimum-variance portfolio (Pro). In other words: Positions weights are changed in order for the portfolio to reveal an optimal risk-return profile.

This portfolio has approximately the same risk as the capitalization weighted index in the long term and is therefore a suitable substitute of a passive core-investment. With respect to e.g. the Swiss Performance Index SPI over the last twelfe years, just by eliminating these structural deficits, an outperformance of approximately 3 % p.a. would have resulted.

 

Performance of the Swiss Equity IsoPro® investment strategy(simulated; live since 2010)
Performance of the Swiss Equity IsoPro® investment strategy(simulated; live since 2010)

Finreon Sustainable IsoPro®

Besides the classical universes (Switzerland, German, Europe, US, World, Emerging Markets and Developed World), the proven concept IsoPro® is also offered on sustainable universes. The latter will be explained in more detail below.

 

Why to invest in a sustainable way? In the long run, successful economic activity can only take place in line with society and nature. Climate change, rapid depletion of resources and social conflicts are just some examples where short-sighted thinking leads to huge social costs for future generations. Investing in companies that strive for a sustainable business model can actively support the transition to more sustainable forms of economic activity.

How to ensure sustainability? It is important to distinguish whether companies only pay lip service or actually undertake serious efforts in the area of sustainability. For this evaluation, specialists are needed. That is why Finreon cooperates closely with Inrate, one of the most important and respected sustainability rating agencies in Europe.

Separation of sustainability rating and portfolio construction
Separation of sustainability rating and portfolio construction

Existing sustainability approaches mix the selection of sustainable stocks and their weighting within the portfolio. The focus often lies on sustainability, while the portfolio characteristics are neglected. This usually leads to hidden concentration risks and inadequate risk control. Such a portfolio is inefficient from a risk-return perspective. If, adversely, the portfolio construction is prioritized, a reduced sustainability is often accepted in order to achieve the desired portfolio characteristics.

A separation of sustainability and portfolio construction with a specialist for both topics, however, ensures that the concept of sustainability is considered appropriately. Moreover, the hidden concentration risks are resolved during the portfolio construction stage. In the long run, a strict focus on risk reduction, improved diversification and cost-effective implementation enables the Sustainable IsoPro® concept to achieve a risk-adjusted outperformance relative to the market-capitalization weighted benchmark.

 

The IsoPro® product range

Swiss Equities

Swiss Equity IsoPro®
Investment universe contains 75 of the largest Swiss stocks

World Equities

World Equity IsoPro®
Investment universe contains 500 of the largest stocks worldwide

Emerging Markets Equity IsoPro®
Investment universe contains 200 of the largest equities from developing countries

Developed World Equity IsoPro®
Investment universe contains 500 of the largest equities from developed countries

US Equities

US Equity IsoPro®
Investment universe contains 400 of the largest US stocks

European Equities

European Equity IsoPro®
Investment universe contains 150 of the largest European stocks
 
German Equity IsoPro®
Investment universe contains 50 of the largest German stocks
 

 

Sustainable World Equities

Sustainable Developed World Equity IsoPro®
Investment universe contains 250 of the largest, sustainable stocks from developed countries worldwide

Sustainable Emerging Markets Equity IsoPro®
Investment universe contains 125 of the largest, sustainable equities from developing countries
 
 

 

Sustainable Equity Switzerland

Sustainable Swiss Equity IsoPro®
Investment universe contains 30 of the largest, sustainable Swiss stocks

Discover IsoPro®  Investment opportunities in our Fund overview

 

 

Smart Beta Solutions: Overview