What Is Smart Beta?

Smart beta investing represents an innovative approach that merges characteristics of passive and active investment strategies. It aims to generate excess returns (alpha), manage risk, and enhance diversification—typically at a cost that is lower than traditional active management and somewhat higher than conventional index investments. Smart beta seeks to construct an optimally diversified portfolio, leveraging principles from both the efficient-market hypothesis and value investing. This approach can apply to various asset classes, including equities, fixed income, commodities, and multi-asset strategies.

Smart Beta Explained

At its core, smart beta is a strategy that diverges from traditional market capitalization-based indices by utilizing alternative index construction rules. The focus of smart beta is to exploit specific investment factors or market inefficiencies in a systematic and transparent manner. Its rising popularity corresponds with a growing interest in effective portfolio risk management and improved diversification along various factor dimensions, with a goal of enhancing risk-adjusted returns when compared to standard cap-weighted indices.

Smart beta strategies passively track selected indices, but they apply various alternative weighting schemes based on factors such as volatility, liquidity, quality, value, size, and momentum. This rules-based approach allows smart beta funds to concentrate on parts of the market that exhibit exploitable opportunities, rather than simply following conventional indices like the S&P 500 or the Nasdaq 100.

Key Takeaways

• Smart beta combines the benefits of passive and active investing.
• It employs alternative index construction rules to traditional indices.
• Smart beta emphasizes transparency and rules-based investment strategies.
• Common alternative weighting schemes used include those based on factors such as volatility and value.
• As of 2019, smart beta funds held approximately $880 billion in cumulative assets.

Selecting Smart Beta Strategies

There is no one-size-fits-all approach to implementing smart beta, as the objectives of investors can differ based on their unique financial situations and goals. Some managers are prescriptive, seeking smart beta ideas that are both value-adding and economically sound. The strategies include:

• Equity Smart Beta: This method aims to identify inefficiencies stemming from market-capitalization-weighted benchmarks. Thematic approaches might focus on mispricing caused by short-term investor behaviors.

• Fundamentally Weighted Indexes: Some managers opt to weight investments based on fundamental characteristics such as earnings or book value, which can offer a different perspective compared to market cap-weighting.

• Risk-Weighted Approaches: This involves creating indices based on assumptions about future volatility. Managers evaluate historical performance and correlations between risks and returns to establish appropriate index frameworks.

Smart Beta Popularity

Despite generally higher fees associated with smart beta funds compared to standard funds, their appeal remains strong among investors. In February 2019, data indicated that 77 new smart-beta exchange-traded funds (ETFs) had been launched, representing about a third of all ETFs introduced that year. During the same timeframe, smart beta funds experienced a robust growth rate in assets under management (AUM), rising by 10.9%—significantly higher than the 4.3% growth seen in traditional funds. Overall, the total assets commanded by smart beta funds increased from $616 billion in 2016 to approximately $880 billion by early 2019.

Examples of Smart Beta Funds

Several smart beta funds employ specific strategies aimed at capturing value, growth, and dividend appreciation. Here are three notable examples:

1. Vanguard Value Index Fund ETF Shares (VTV):
2. Strategy: This fund tracks the CRSP US Large Cap Value Index, evaluating value through various fundamental ratios like price-to-book and dividend yield.

3. AUM: As of April 2019, VTV had assets totaling approximately $77.25 billion.

4. iShares Russell 1000 Growth ETF (IWF):

5. Strategy: This ETF seeks returns in line with the Russell 1000® Growth Index by assessing components through price-to-book and sales growth factors.

6. AUM: As of April 2019, IWF was managing around $42.73 billion in assets.

7. Vanguard Dividend Appreciation Index Fund ETF Shares (VIG):

8. Strategy: This fund aims to mirror the Nasdaq US Dividend Achievers Select Index by focusing on firms with a solid history of increasing dividend payments.
9. AUM: As of April 2019, VIG managed about $40.94 billion.

Conclusion

Smart beta investing has become a significant force in the investment landscape, offering investors an attractive blend of passive management's simplicity and active management's strategic focus. By leveraging different indices and alternative weighting methods, smart beta funds allow investors to pursue specific objectives while maintaining a level of cost-efficiency. As interest in factor-based investing continues to grow, smart beta strategies promise to remain a vital component of modern portfolio management.