Smart beta refers to an investment strategy that combines elements of passive index investing with those of actively managed investing. The ultimate goal is to outperform a benchmark index while retaining the lower risk and low volatility that are typically mentioned as key elements of index investing.
Investment professionals have varying views on whether smart beta accomplishes its objectives or, as many skeptics have claimed, is more appropriately labeled “smart marketing.” Learn the theory behind smart beta, how it works, and what its pros and cons are.
Definition and Examples of Smart Beta
Smart beta is an investment strategy that’s a hybrid of passive index investing and actively managed investing intended to outperform a benchmark index. Smart beta incorporates the better parts of passive index investing—low risk and less volatility—with the prospect of the better performance of actively managed funds but with lower expenses.
Smart beta investment strategies are primarily available to individual investors through ETFs. They are considered a hybrid between passive index funds and actively managed funds because they seek to outperform the market index while maintaining low turnover and offering lower expenses than an actively managed fund.
How Smart Beta Works
To understand the term “smart beta,” it is necessary to review the meaning of beta as it applies to investing. Beta is a means of measuring a stock’s volatility in relation to the overall market (i.e., the S&P 500). The S&P 500’s beta is expressed as 1.0. If a stock historically has been more volatile than the S&P 500, its beta will be higher than 1.0.
For example, a stock that is 20% more volatile than the S&P 500 has a beta of 1.2. Any stock with a beta over 1.0 is considered riskier than the index, but also should increase in value more than the index when the market is up. If the S&P increases 10% in a time period, the stock with a 1.2 beta should increase 12% during that same period. Conversely, stocks with a beta lower than 1.0 pose less risk than the index, but also are likely to have lower returns.
Beta only measures a stock’s volatility in relation to the market, not whether it performs better or worse than the market. Thus, a stock that performs 50% better than the S&P 500 in an up market and a stock that performs 50% worse in a down market will both have a high beta.
Types of Smart Beta Strategies
Traditional market index funds and ETFs are “capitalization-weighted.” That is, the individual stocks within the fund are based on each stock’s market capitalization. A handful of large-cap stocks can represent a large percentage of the index’s total value.
Smart beta strategies attempt to outperform traditional market indexes while improving diversification and reducing risk by exploiting one or more performance factors other than market capitalization, such as momentum, earnings, volatility, or dividend growth. Multiple factors may be weighted equally or separated into tiers.
Smart beta strategies can be used for fixed income investments as well as stocks, and offer the same benefits—increased diversity, less dependence on size, and potentially lower risk.
Pros and Cons of Smart Beta Investing
Multiple investing strategies
Lower expenses than actively managed funds
Lack of evidence that it’s a reliable strategy
Can be complicated
Higher expenses than index funds
- Multiple investing strategies: Smart beta ETFs ostensibly offer investors a way around the simple capitalization-weighted investing of index funds through a variety of strategies that can match an investor’s investing style.
- Lower expenses than actively managed funds: Smart beta ETFs generally do have lower expenses than actively managed funds.
- Lack of evidence that it’s a reliable strategy: Research has shown when the performance of smart beta ETFs is assessed against the blended benchmark, the smart beta theme portfolios do not consistently deliver significant benchmark-adjusted returns.
- Can be complicated: The rules of individual smart beta ETFs can be complex and leave investors uncertain about what strategies they are truly following.
- Higher expenses than index funds: Smart beta ETFs tend to be more expensive than index funds.
Alpha vs. Beta
Whereas beta measures volatility, alpha measures the difference between a portfolio’s expected return and its actual performance, taking into account the level of risk as measured by beta. The baseline measure for alpha is zero.
A fund that returned 12% in a year when the S&P 500 returned 8% would have a higher alpha, while a fund that returned less than 8% would have a negative alpha. Naturally, investors seek funds whose management has a high alpha. However, investors who are less aggressive will balance the alpha against the beta.
As fund investors are always warned, past performance is no guarantee of future results.
What It Means for Investors
Investors often seek ways to outperform the market in good and bad times. Smart beta funds aim to outperform index funds in both up and down markets while providing lower volatility. However, investors should carefully research any smart beta investment vehicles they are considering to make sure the strategy matches their objective, and to assess the performance of the fund over various periods compared with index funds.
- Smart beta funds are a hybrid between index funds and actively managed funds.
- They seek to outperform index funds by exploiting one or more performance factors other than market capitalization. These may include momentum, liquidity, earnings, volatility, or dividend growth.
- Smart beta investment strategies can be used for fixed income assets like bonds as well as stocks.
- Smart beta funds generally have lower expenses than actively managed funds but higher expenses than index funds.