Smart beta is a fancy term for an investment strategy that seeks to outperform a traditional stock index by reweighting the stocks in that index. Itâ€™s a popular strategy, and index managers have created many smart beta indexes that try to earn higher returns with lower risk. Itâ€™s like a hybrid approach â€” using elements from both passively and actively managed styles.
Smart beta has become a popular investing strategy, having amassed more than $1 trillion in assets by the end of 2017, doubling total assets in just three years. Such strong growth is due to the fundsâ€™ promise of higher risk-adjusted returns than conventional index funds offer.
Conventional indexes such as the S&P 500 are weighted by a companyâ€™s size. The bigger the firm, the higher its weight in the index. If you buy and hold a fund based on this index, youâ€™ll get the S&P 500â€™s yearly return over time (an average of 10% to 11% historically, which isnâ€™t bad).
But smart beta indexes seek to do even better. They try to outperform an index such as the S&P 500 while buying the same stocks, only in different proportions. These new indexes select and weight stocks based on criteria that index managers think will lead to a stockâ€™s rise, making them â€śsmartâ€ť funds. Beta is a measure of a stockâ€™s volatility, so these indexes seek stocks that deliver the most â€śbangâ€ť for the beta â€” in other words, high returns with low risk.
These indexes are mimicked by smart beta funds and are reweighted whenever the index changes. Both exchange-traded funds and mutual funds offer smart beta, and there are many different kinds of smart beta strategies, depending on the characteristics an investor wants.
Each manager has their own way of dicing the conventional index to find outperformance. Managers will analyze and sift the data for what actually drives a stockâ€™s returns, not only at the business but also relative to the economyâ€™s position in the business cycle. How a manager picks these stocks for the index has a key impact on an investorâ€™s overall returns, and one managerâ€™s approach and stock weightings can differ from anotherâ€™s, even if they share the same style.
Here are some of the most popular smart beta styles:
Unlike standardized funds that are based on the S&P 500 or the Nasdaq composite, funds with the same style offer no guarantee that theyâ€™ll be the same on the inside. And a fund itself will shift as managers alter the index in response to new analysis or changing market conditions.
In fact, you should expect each fund to be created differently. After all, youâ€™re paying the manager extra for this expertise â€” to try to find that increased return without the extra risk.
Smart beta funds promise investors higher risk-adjusted returns than conventional index funds or strategies. That means investors could earn the same return with lower risk or perhaps a higher return with the same risk as a conventional fund. So investors get a â€śfree lunchâ€ť without having to compromise. If the manager can achieve that goal, itâ€™s a win for investors.
And thereâ€™s some evidence that at least some managers can do this. In a 2018 analysis, investment manager Invesco examined smart beta strategies from 1991 to 2017 across five market cycles. Researchers discovered that all smart beta strategies produced the same or better total returns than the S&P 500, while the majority produced better risk-adjusted returns.
If smart beta works as promised, investors get higher risk-adjusted returns (at least most of the time) while enjoying the benefits of a diversified stock portfolio.
Remember what they say about free lunches? Thereâ€™s maybe no such thing in the case of smart beta investing, at least in aggregate. Smart beta may excel for a time, but as an approach becomes more popular, it loses its ability to outperform. To say this another way, in the game of stock trading, one personâ€™s win is always anotherâ€™s loss. Outperformance for one smart beta fund means underperformance for another smart beta fund.
It may still be possible to find a smart beta fund that can outperform the market, but in aggregate, smart beta wonâ€™t do better than a passive approach. In fact, because of higher fees paid to active managers, it will cost more, dragging the average investorâ€™s overall returns lower. So if youâ€™re looking for a smart beta fund, choose one with a track record of outperformance.
On the subject of fees, some analysts estimate the average smart beta fund costs about 0.35% to 0.39%, or $35 to $39 for every $10,000 invested, though fees have been falling. Thatâ€™s not especially high, but itâ€™s still well above some of the lowest-cost S&P index funds, such as the Schwab S&P 500 (SWPPX) at 0.03%, or $3 for each $10,000. So any smart beta fund you choose must outperform by that extra cost just to break even over the cheaper fund. While it may seem small, that little difference adds up over a lifetime of saving and investing.
One other concern may be harder to detect for investors, and it revolves around the question of risk. Index managers are creating indexes that purport to lower risk while still achieving returns. However, itâ€™s possible that a manager is taking on too much risk to achieve that return. So returns can look good during a bull market, but they can turn much worse during a bear market. Worse, itâ€™s hard for an investor to make a call on whether a fund is taking on too much risk.
Smart beta has become popular because of its promise to provide investors with better risk-adjusted returns. While thereâ€™s some evidence of that, not all strategies can always be winners. Itâ€™s just not the way the world of investing works.
But it may be possible to find a manager who is able to consistently outperform with smart beta, and if so, itâ€™s important to stick to the same buy-and-hold mentality that drives the returns of many great investors.
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