What Is a Smart Beta Strategy?

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Updated on Thursday, December 13, 2018

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Smart beta is a fancy term for an investment strategy that seeks to outperform a traditional stock index by reweighting the stocks in that index. It’s a popular strategy, and index managers have created many smart beta indexes that try to earn higher returns with lower risk. It’s like a hybrid approach — using elements from both passively and actively managed styles.

How smart beta works

Smart beta has become a popular investing strategy, having amassed more than $1 trillion in assets by the end of 2017, doubling total assets in just three years. Such strong growth is due to the funds’ promise of higher risk-adjusted returns than conventional index funds offer.

Conventional indexes such as the S&P 500 are weighted by a company’s size. The bigger the firm, the higher its weight in the index. If you buy and hold a fund based on this index, you’ll get the S&P 500’s yearly return over time (an average of 10% to 11% historically, which isn’t bad).

But smart beta indexes seek to do even better. They try to outperform an index such as the S&P 500 while buying the same stocks, only in different proportions. These new indexes select and weight stocks based on criteria that index managers think will lead to a stock’s rise, making them “smart” funds. Beta is a measure of a stock’s volatility, so these indexes seek stocks that deliver the most “bang” for the beta — in other words, high returns with low risk.

These indexes are mimicked by smart beta funds and are reweighted whenever the index changes. Both exchange-traded funds and mutual funds offer smart beta, and there are many different kinds of smart beta strategies, depending on the characteristics an investor wants.

Types of smart beta funds

Each manager has their own way of dicing the conventional index to find outperformance. Managers will analyze and sift the data for what actually drives a stock’s returns, not only at the business but also relative to the economy’s position in the business cycle. How a manager picks these stocks for the index has a key impact on an investor’s overall returns, and one manager’s approach and stock weightings can differ from another’s, even if they share the same style.

Here are some of the most popular smart beta styles:

  • Value: an approach that emphasizes stocks that are cheaper relative to earnings or cash flow
  • Dividends: a style that favors dividend-paying companies or those showing dividend growth
  • Momentum: an approach that includes stocks that have been trending higher
  • Low volatility: a weighting that emphasizes stocks that move around less
  • Business quality: a style that factors in more company-based metrics, including return on equity, low debt and consistently growing earnings
  • Equal weighted: an approach that balances every stock in the index equally

Unlike standardized funds that are based on the S&P 500 or the Nasdaq composite, funds with the same style offer no guarantee that they’ll be the same on the inside. And a fund itself will shift as managers alter the index in response to new analysis or changing market conditions.

In fact, you should expect each fund to be created differently. After all, you’re paying the manager extra for this expertise — to try to find that increased return without the extra risk.

The advantages of smart beta investing

Smart beta funds promise investors higher risk-adjusted returns than conventional index funds or strategies. That means investors could earn the same return with lower risk or perhaps a higher return with the same risk as a conventional fund. So investors get a “free lunch” without having to compromise. If the manager can achieve that goal, it’s a win for investors.

And there’s some evidence that at least some managers can do this. In a 2018 analysis, investment manager Invesco examined smart beta strategies from 1991 to 2017 across five market cycles. Researchers discovered that all smart beta strategies produced the same or better total returns than the S&P 500, while the majority produced better risk-adjusted returns.

If smart beta works as promised, investors get higher risk-adjusted returns (at least most of the time) while enjoying the benefits of a diversified stock portfolio.

The risks of smart beta investing

Remember what they say about free lunches? There’s maybe no such thing in the case of smart beta investing, at least in aggregate. Smart beta may excel for a time, but as an approach becomes more popular, it loses its ability to outperform. To say this another way, in the game of stock trading, one person’s win is always another’s loss. Outperformance for one smart beta fund means underperformance for another smart beta fund.

It may still be possible to find a smart beta fund that can outperform the market, but in aggregate, smart beta won’t do better than a passive approach. In fact, because of higher fees paid to active managers, it will cost more, dragging the average investor’s overall returns lower. So if you’re looking for a smart beta fund, choose one with a track record of outperformance.

On the subject of fees, some analysts estimate the average smart beta fund costs about 0.35% to 0.39%, or $35 to $39 for every $10,000 invested, though fees have been falling. That’s not especially high, but it’s still well above some of the lowest-cost S&P index funds, such as the Schwab S&P 500 (SWPPX) at 0.03%, or $3 for each $10,000. So any smart beta fund you choose must outperform by that extra cost just to break even over the cheaper fund. While it may seem small, that little difference adds up over a lifetime of saving and investing.

One other concern may be harder to detect for investors, and it revolves around the question of risk. Index managers are creating indexes that purport to lower risk while still achieving returns. However, it’s possible that a manager is taking on too much risk to achieve that return. So returns can look good during a bull market, but they can turn much worse during a bear market. Worse, it’s hard for an investor to make a call on whether a fund is taking on too much risk.

Bottom line

Smart beta has become popular because of its promise to provide investors with better risk-adjusted returns. While there’s some evidence of that, not all strategies can always be winners. It’s just not the way the world of investing works.

But it may be possible to find a manager who is able to consistently outperform with smart beta, and if so, it’s important to stick to the same buy-and-hold mentality that drives the returns of many great investors.

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