What is Smart Beta and can it give your wallet a boost?

Smart beta investing strategies have become incredibly popular. From 2012 to 2017, the value of smart beta funds grew by almost 30% per year and exceeded $ 1 trillion in assets in 2017.
But while he’s popular, what does that mean? One of the most confusing classifications of exchange traded funds is “smart beta”. Unlike the relatively simple names of many ETFs, such as the S&P 500 ETF or the Dividend Growth ETF, it takes some decryption to understand what is so “smart” and “beta” about these investments.
Smart beta at a glance
The fundamental goal of a smart beta strategy is to outperform a traditional stock market index by selectively picking and reweighting stocks in the index. It is a “smart” index because it tries to increase returns by buying a greater proportion of stocks with predetermined criteria which, according to the asset manager, will lead to outperformance. “Beta” refers to the volatility or risk of an individual stock. Such smart beta funds seek better risk-adjusted returns than traditional index funds. In other words, they try to get higher returns (smarter) without being more risky (more beta).
“Smart beta funds seek to outperform traditional index funds without being more risky.“
To understand how a smart beta index differs from a conventional index, you first need to know what a conventional index is for. Usually, the most common indices, such as the S&P 500, which tracks the largest companies in the United States, are weighted by the size of a company. The larger the company, the more weight it has in the index. It’s true whether small businesses 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. Funds select stocks based on criteria that are considered important, and when a stock meets the criteria, it may have more weight in the index.
This approach makes smart beta more akin to a passive strategy than an active strategy, 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 because stocks that meet the criteria for the index change and are reweighted in the index. While a purely passive approach keeps fees lowest, a smart beta strategy can be more expensive, but still cheaper than a traditional actively managed fund.
The allure of smart beta
So investors like smart beta because it promises potentially better than the market returns, diversification and lower risk. This promise has boosted their popularity for the past 15 years since the creation of the first smart beta fund in 2003.
While there is only one term for this approach, smart beta has many flavors, depending on what an investor is looking for. A smart beta fund can define its preference for:
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Dividends: Stocks that pay large dividends or show strong dividend growth
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Low volatility: Stocks that fluctuate less than the average
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Momentum: Stocks that have strong upward price movements
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Commercial grade: Companies with strong operational characteristics, such as high profit margins
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Evaluation: Stocks that look cheap relative to earnings or cash flow
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Cut: Companies factored by the total value of their shares
But it’s important to remember that each of these funds would be different. One valuation-based asset manager’s smart beta fund is unlikely to look like another’s. This is in stark contrast to S&P 500-based ETFs, where all funds look virtually identical, regardless of the provider.
Due to the major differences in the makeup of smart beta funds, investors need to look at a fund and its performance over time. This information is readily available on the asset manager’s website.
How is smart beta performing?
Long-term study shows that it performs well relative to a benchmark S&P 500 index fund. Asset manager Invesco looked at the performance of five factors (such as low volatility, momentum and quality of business. ) and five alternative weights from 1992 to 2015.
The results seemed favorable:
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“All five factors and five alternative weighting methodologies… resulted in higher absolute returns compared to the S&P 500 Index.”
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“The majority of smart beta strategies have generated higher risk-adjusted returns than the S&P 500 Index.”
Smart beta strategies weren’t always successful at particular times. Invesco has studied the strategies over five full market cycles and noted that during certain periods of time, traditional market capitalization-weighted indices (like the S&P 500) have outperformed Smart Beta. Nonetheless, Invesco concludes that throughout this time, the smart beta approach has been successful, with “a clear pattern of outperforming the S&P 500”.
Interested in smart beta?
It’s easy to buy a smart beta fund, and you can buy them just like you would any normal stock. This means that you will need a brokerage account to get started. Here are our choices for the best brokers for ETF investors.