Smart beta — also known as advanced beta, alternative beta or strategy indices — isn’t a new investment strategy. But lesser-known strategies have a way of surfacing and gaining credibility during times of market stagnation, volatility or other conditions of uncertainty. Such was the case during the stock market meltdown of 2007–2009. In such a market, investment managers were looking to reduce risk, rather than just purely pursuing return.
Enter smart beta. Since the market seems to be on a range-bound course, smart beta may have some merit.
What Is Smart Beta?
Smart beta tries to balance better risk and return tradeoff and does so by using alternative weighting strategies based on measures such as dividends and volatility.
However, smart beta isn’t necessarily a well-defined investment strategy. Investopedia defines it as follows:
“Smart beta defines a set of investment strategies that emphasize the use of alternative index construction rules to traditional market capitalization based indices. Smart beta emphasizes capturing investment factors or market inefficiencies in a rules-based and transparent way. The increased popularity of smart beta is linked to a desire for portfolio risk management and diversification along factor dimensions as well as seeking to enhance risk-adjusted returns above cap-weighted indices.”
Okay, so what does this definition mean in simple English? Smart beta is something of a hybrid investment strategy that blends index investing with active portfolio management.
The key here is the term market inefficiencies. The fund manager invests basically in index funds, but at the same time he or she seeks to exploit inefficiencies within stocks or sectors within the index.
For example, though the manager may invest primarily in index funds, he might exploit one or two sectors, or sectors within an index that represent particular bargains compared to the general market.
Smart beta can also include returns from illiquid — or private — markets. This can include real estate and infrastructure that offer attractive risk/return tradeoffs. This strategy can also offer greater investment diversification when added to a portfolio comprised mostly of equities and bonds.
Think of smart beta as index investing while also tilting the playing field in a more favorable direction.
Smart Beta Means Lower Costs
With smart beta the manager passively follows an index designed to take advantage of perceived systemic biases or inefficiencies in the market. Since it uses primarily an index fund, the investor benefits from the lower costs associated with index funds, versus actively managed funds.
Since index funds trade far less frequently than actively managed funds do, there will be lower transaction costs, as well as fewer taxable capital gains.
This isn’t to say smart beta investing is completely comparable with index funds when it comes to investment expenses. Though a smart beta fund may trade far less than an actively managed fund, it will usually trade more than a true index fund.
How Big Is Smart Beta Investing?
According to an article appearing on Morningstar, assets in smart beta funds totaled $441 billion on March 31, 2015, or 26.6% of assets in all stock ETFs.
What’s more, the numbers are steadily growing. What was once thought of as an investment fad has now morphed into a serious investment phenomenon.
Smart Beta Funds vs. the Underlying Index
This is the real test of the effectiveness of smart beta as an investment strategy — and the results are mixed. Invesco PowerShares FTSE RAFI US 1000 Portfolio is a good example, but even here the results are less than absolute.
The fund started in December 2006, and for its first five years, it outperformed its underlying index, the Russell 1000, 15.1% to 10.2%. That certainly supports the smart beta concept as being superior to a straight-up index fund.
But more recent performance has been less certain. Over the most recent three-year period, the fund underperformed the Russell 1000, 19.5% vs. 32.0%, and 55.1% vs. 68.1%) over the past five years. It is, however, doing better year-to-date, through June 28, 2016, +0.7% vs. –0.9%.
Again, this fund is a good example. Many other smart beta funds that have been around for much less time and/or are underperforming their underlying indices. And at that, there are several problems in measuring the success of smart beta funds:
- As noted above, performances can be erratic (vs. the underlying index).
- Many of the funds have only come into existence since 2009 (many are even more recent), and there is no track record to determine how they would perform in a major market decline.
- Exactly what constitutes a smart beta fund is not always clear.
Is Smart Beta the Way to Go?
I don’t know with any certainty whether using smart beta is the best way to go. In theory at least, smart beta investing seems to combine the low fees of index funds with the prospect of higher returns based on a certain limited degree of active intervention by management. But that’s a sword that cuts both ways — active management could be the reason why the fund also underperforms the market.
Just as is the case with actively managed funds, your performance will be no better than the person or people who are managing the portfolio.
If you’re looking for passive equity investing, regular index funds are the way to go. If you’re willing to take on the additional risks that are an inherent part of smart beta investing, then that’s certainly worth considering.
Have you tried your hand at smart beta investing? What are your thoughts?