Smart beta investing strategies have become incredibly popular. From 2012 to 2017, the value of smart beta funds grew at almost 30% annually, and surpassed $1 trillion in assets in 2017.
But while it’s popular, what the heck does it mean? "Smart beta" is one of the more confusing classifications of exchange-traded funds. Unlike the relatively straightforward names of many ETFs — such as the S&P 500 ETF or Dividend Growth ETF — it takes some deciphering to figure out what is so "smart" and "beta" about these investments.
Smart beta in a nutshell
The basic aim of a smart beta strategy is to outperform a traditional stock index by selectively choosing and re-weighting the stocks in the index. It’s a “smart” index because it tries to increase returns by buying a larger proportion of stocks with the predetermined criteria that the asset manager thinks will lead to outperformance. “Beta” refers to how volatile or risky an individual stock is. So smart beta funds seek to achieve better risk-adjusted returns than traditional index funds. In other words, they try to achieve higher returns (smarter) without being more risky (more beta).
“Smart beta funds seek to achieve better returns than traditional index funds without being more risky.”
To understand how a smart beta index differs from a conventional index, you have to first know what a conventional index does. Usually, the most common indexes, such as the S&P 500, which tracks the largest companies in the U.S., are weighted by a company’s size. The bigger the company, the more weight it holds in the index. That’s true regardless of whether smaller companies are growing faster or paying a better dividend or trading for a low valuation.
Smart beta strategies identify stocks in the index with these other, perhaps better qualities and make them a bigger part of a smart beta fund. The funds screen for stocks based on criteria deemed important, and when a stock meets the criteria it can carry more weight in the index.
This approach makes smart beta more akin to a passive strategy than an active one, and these funds typically don’t have managers trying to beat the market. However, smart beta funds trade in and out of the market more frequently than a typical index fund, as the stocks that meet the index’s criteria change and are re-weighted in the index. While a purely passive approach keeps fees the lowest, a smart beta strategy can be more expensive, though still cheaper than a traditional actively managed fund.
The appeal of smart beta
So investors like smart beta because it promises potentially market-beating returns, diversification and lower risk. This promise has driven their popularity over the past 15 years since the first smart beta fund was created in 2003.
While there’s just one term for this approach, smart beta has many flavors, depending on what an investor is looking for. A smart beta fund can set its preference for:
Dividends: Stocks that pay big dividends or show strong dividend growth
Low volatility: Stocks that fluctuate less than the average
Momentum: Stocks that have strong upward price movements
Business quality: Companies that exhibit strong operational characteristics, such as high profit margins
Valuation: Stocks that appear cheap relative to earnings or cash flow
Size: Companies factored by the total value of their stock
But it’s important to remember that each of these funds would be different. One asset manager’s smart beta fund based on valuation is probably not going to look like another’s. That’s in sharp contrast to ETFs based on the S&P 500, where all funds look virtually identical, no matter the provider.
Because of major differences in the composition of smart beta funds, investors have to examine a fund and how it has performed over time. This information is readily available on the asset manager’s website.
How has smart beta performed?
One long-term study shows it is performing well, relative to a benchmark S&P 500 index fund. Asset manager Invesco studied the performance of five factors (such as low volatility, momentum and business quality) and five alternative weightings from 1992 to 2015.
The results looked favorable:
“All of the five factors and five alternative weighting methodologies … resulted in higher absolute returns relative to the S&P 500 index.”
“The majority of smart beta strategies delivered higher risk-adjusted returns than the S&P 500 index.”
Smart beta strategies weren’t always the winners at particular points in time. Invesco studied the strategies over five full market cycles and noted that during some periods traditional, market-cap-weighted indexes (such as the S&P 500) outperformed smart beta. Still, Invesco concludes that over that entire time, the smart beta approach was a winner, with “a clear pattern of outperformance relative to the S&P 500.”
Interested in smart beta?
It’s easy to buy a smart beta fund, and you can purchase them just as you would any normal stock. That means you’ll need a brokerage account to get started. Here are our picks for the best brokers for ETF investors.