Over the last few years, smart beta funds have become very popular; in fact, since the first smart beta fund opened, more than $1.4 trillion has been invested in these funds. Smart beta funds seek to achieve higher returns than those earned with normal index funds while still maintaining relatively low expense ratios. Read on to learn more.
What is smart beta?
To understand smart beta, it’s helpful to understand a little about index funds. Let’s take the S&P 500, an index often used to gauge US equity performance. The S&P 500 is a weighted-index based on the market capitalization (total value of outstanding shares) of the various companies. Recently, this index showed substantial positive and negative moves on the basis of a few large tech firms.
Smart beta funds can be created to counter this weighting. For instance, some smart beta funds are evenly weighted, so that no matter their size each company has an equal rating. Other smart beta funds seek to achieve lower volatility, so stocks may be weighted by their historical beta.
Note: Beta measures a stock’s volatility. A beta of 1 would move in lockstep with its index, while one of 1.2 would be 20% more volatile than its index.
Mix of passive and active investing
Some people have described smart beta funds as a mix of active and passive investing. The fund company looks at different factors (like volatility, stock price momentum, low debt, consistency in dividend payments, etc.) and weights stocks based on factors they choose for the fund. For instance, a company setting up a value smart beta ETF may look for US stocks with lower valuations based on company fundamentals. Once they set the rules, smart beta funds can’t make adjustments. Once the strategy is created, the implementation of that strategy is passive.
Pros of smart beta investing
Higher returns. Smart beta funds have the potential to achieve greater returns than market-cap-weighted index funds.
Strategies to align with investor needs. There are many variations of smart beta funds. If you want reduced volatility or need income with a dividend-focused fund, there’s an option for you.
Lower fees. Smart beta funds have lower fees than actively managed funds.
Cons of smart beta investing
Underperformance. As we’ve seen, sometimes those massive tech firms will outperform, leading an index higher than an equally-weighted index. Also, as people have become aware of smart beta, money has quickly followed, leading many firms to create even more offerings. These funds are only as good as their strategies, some of which haven’t consistently beaten the underlying index.
Too many complex choices. Just as investors started to realize that index funds may be the best avenue for achieving their long-term goals, another choice has appeared. Many people won’t want to study and understand the difference between market-weighted and equal-weighted, or why volatility matters.
Higher fees. While fees for smart beta funds are normally less than actively managed funds, they are higher than index funds, sometimes by a large amount. That means a smart beta fund must outperform by at least that difference in fees to make them worthwhile.
Are they right for you?
While smart beta funds have been around since the early 2000s, they only recently have become popular with everyday investors. We’re starting to see reports about their performance during the recent downturn versus index funds. The problem of course is there are so many variations, it’s hard to say yes, they’ve outperformed. Some showed positive returns while the markets were down 20%; others were down as much or more.
FINRA assembled a list of considerations if you want to purchase a smart beta fund. You should investigate the fund using these, but also check to see their performance in up and down markets. Past performance is no guarantee of any future results, but it can help you see if the fund is simply mirroring the index or actually providing value.
Photo by Patrick Weissenberger