International Smart Beta Fund Pros and Cons

Are Smart Beta Funds a Smart Bet?

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There has been a lot of talk surrounding so-called smart beta investing in the financial press over the past several years. In 2015, smart beta exchange-traded funds (ETFs) and mutual funds attracted more than $70 billion worth of capital with total assets of about a half trillion dollars. Many international investors look towards these funds to enhance risk-adjusted returns in markets that are perceived to be less efficient than domestic markets.

In this article, we’ll briefly review what smart beta funds are and then take a look at some of the pros and cons of investing in smart beta ETFs and mutual funds.

Smart Beta 101

Smart beta funds are simply index funds that are weighted by something other than size. For example, the funds may go overweight in equities that have high dividends, low volatility, favorable fundamentals, or strong price momentum. The idea is that these equities are better positioned than others in a given index to outperform; therefore, an investor might increase their risk-adjusted returns by allocating a greater percentage of their portfolio to them.

For example, a low volatility smart beta ETF may weight its portfolio based on a combination of market capitalization and beta coefficients. The goal for the portfolio may be to reduce risk stemming from volatility and increase risk adjusted returns for investors.

These strategies can often be back tested based on historical data in order to provide an idea of what returns may be generated from the strategy had it been implemented in the past.

There are many different smart beta fund providers, including some of the largest ETF issues, like BlackRock’s iShares and Fidelity’s portfolios.

Often times, these funds carry slightly higher expense ratios than passively managed index funds, although they are cheaper than many actively managed ETFs and mutual funds. This means that they could fill a key void in cases where investors are interested in a specific strategy, but want to save on expenses over time.

Pros of Smart Beta Funds

The weighting of ETFs and mutual funds by market capitalization may seem somewhat arbitrary. Successful investors like Warren Buffett and Peter Lynch have used a combination of criteria to determine what constitutes a high quality company. The advent of ultra-fast computers to assist with equity analysis has made it possible to quickly quantify nearly any component of a company in order to make an investment decision.

Smart beta funds may also be useful in specific scenarios. For example, an investor that’s nearing retirement may leverage low beta smart beta funds in order to reduce their portfolio risk while remaining invested in the same underlying index as an index fund. Similarly, an income investor may seek out a high dividend smart beta fund in order to maximize income while maintaining exposure to the same underlying index as an index fund.

Cons of Smart Beta Funds

Critics of smart beta funds aren’t confident that their returns are sustainable. According to Research Affiliates, many of these funds are chasing recent past performance rather than developing a true edge in the market. The value added by these funds may be coming primarily from the securities getting more popular and expensive. In other words, investors may be paying too much for smart beta qualifies like “low volatility” or “high dividends”.

International investors may face further risks stemming from smart beta funds targeting elements like currency risk. For example, currency-hedged smart beta funds may remove currency risk from an international investment portfolio. This may negate the effect of a foreign currency and could reduce the portfolio’s overall diversification.

After all, the portfolio would retain its ties to the movement of the U.S. dollar.

Key Takeaway Points

  • Smart beta funds have become increasingly popular over the past several years, with more than a half trillion in assets under management in 2015.
  • Smart beta funds can help investors attain specific investment goals, while potentially providing greater returns than arbitrary index investing.
  • Smart beta funds might simply be benefiting from past performance rather than developing a true edge, while potentially introducing new risks.
  • International investors should carefully consider their motivations behind using smart beta funds before integrating them into their portfolios.