The concept of smart beta is gaining traction amongst investors as a viable investment strategy. At the moment, it is more prevalent in equity markets, but is increasingly pushing into fixed income and alternative assets. The Economist magazine ran an article on the topic in July 2013 titled: The Rise of Smart Beta – Terrible Name, Interesting Trend. The Economist’s assessment of the name is rather harsh, but they are correct – the concept is interesting.

As an investment strategy, smart beta sits between market capitalisation and an active strategy (alpha). The growing interest in smart beta is partly to offset the undesirable characteristics of the market capitalisation investment strategy. For example, when an equity market investor maintains a market capitalisation weighted portfolio, they have to invest into strong performing stocks and reduce their position in under-performing stocks. Potentially, this strategy leads to higher allocations to over-valued stocks and an under-weight position on stocks which may have attractive valuations. While the process of mean reversion is neither deterministic nor smooth, there is sufficient empirical evidence to suggest stocks mean revert over the long-term.

A further limitation of the market capitalisation strategy is that sectoral weights are determined by the composition of an individual equity market. As an illustration of this limitation, Financials (excluding property), Materials and Property Trusts account for almost two-thirds of the market capitalisation of the S&P/ASX 200 index. A market capitalisation strategy is, therefore, heavily weighted to these sectors with very low allocations to Education and Health Care, which are among the growth sectors of the Australian economy.

Smart beta is an evolution of the traditional market capitalisation strategy. Three of the widely promoted smart beta investment strategies are:

• Equal weighted portfolio.
• Economically weighted portfolio.
• Minimum volatility portfolio.

What are the implications of smart beta investment strategies for real estate? The first part of any analysis is to estimate the market value of the six CBD office markets (Sydney, Melbourne, Brisbane, Perth, Adelaide and Canberra). This provides a numerator and a denominator for the calculation of the market capitalisation asset allocation strategy. Our modeling estimates a market value figure of AUD 120 billion for the Australian CBD office markets. A market capitalisation asset allocation strategy would imply that Sydney CBD, with a 43% allocation, is the cornerstone of a diversified office portfolio.

A CBD office portfolio constructed using the market weights of 2013 would have generated a return of 10.54% per annum over the past 10 years. An equal-weighted portfolio, however, would have generated a return almost 100 basis points higher at 11.40%.

At first glance, there appears to be some merit in further exploring the application of smart beta investment strategies to commercial real estate. However, we remain cognisant that smart beta strategies can reduce liquidity and with real assets – the idiosyncratic risk factors need to be carefully reviewed and managed.

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