Smart beta might just be the next big thing in investing, but what is it and what can it do for you? At its most basic, smart beta offers investors an alternative to both active and passive management. Active management, which is mostly reliant on a manager’s skill in security selection, seeks to outperform a specific benchmark. Passive management tracks a specific index to obtain beta exposure. Beta measures the volatility of a strategy relative to its benchmark. Smart Beta is trying to bridge the gap between betting on a manager and just getting market returns. Smart beta products aim to generate returns higher than the S&P 500®, for example, without taking the additional risk and higher fees associated with active strategies. Additionally, there is more transparency and liquidity. Smart beta solutions are typically traded in exchange traded funds (ETFs) and with $346 billion invested in these strategies as of May 2014, their popularity is soaring.
The Mechanics of Smart Beta
How can an investment strategy achieve lowered risk and fees without compromising excess returns? While there are many flavors of smart beta, the common feature is that they do not use a company’s market capitalization in the creation of an index fund. A manager will look at other factors, such as value, volatility, cash flow, or sales, when deciding which stocks to buy and how much to own. The strategies are also rules-based, and once the methodology is set, follow the parameters much like an index fund. In this way, they tend to be more transparent and have lower turnover, something likely appealing to many institutional investors.
Incorporating Smart Beta into a Portfolio
The current research suggests that investors use smart beta to complement other, traditional strategies within a portfolio. With this sort of diversification, the thinking goes, an investor may see a more even-keeled performance stream – mitigating both periods of outperformance and underperformance. While it may seem counterintuitive, the investor has the opportunity to avoid huge highs – and lows – depending on their risk tolerance.
David Koenig from Russell Indexes had this to say in a recent Morningstar interview: “It’s important that investors understand the basis for these strategies first of all. Really the true test of strategic or smart beta is whether it’s not just based on some historical back test for outperformance, but rather that it’s based on solid economic or behavioral rationale.”
While smart beta strategies can help investors tailor exposure or mitigate risk, it is important to understand that these are not completely risk-free strategies, nor are they insulated against market volatility. Research has indicated that these strategies can outperform over the long term. However, smart beta may also underperform in the short term. The length of time required to achieve this long-term outperformance may be longer than an investor’s particular time horizon. Therefore, it is important to consider the length of time you have to invest as well as the track record of the strategy.