What is Smart Beta?
“Smart beta” is a set of investment strategies that apply alternative index construction rules to traditional-based indices. Beta is financial jargon for the level of systematic risk of a financial asset that was popularized with the Capital Asset Pricing Model. An asset with high beta has a high systematic risk, and according to the model, it should offer high expected returns to investors. The main message is that for investments with high risk, investors should require higher returns. So, the name “beta” comes from the risk funds take and smarter because these funds claim that they do with a better choice of risks.
Active vs Passive
The investment industry has traditionally been segmented between passive and active approach. In the passive approach, portfolios are constructed to track a market index and there is almost no work in selecting securities: they are predetermined by the index composition. In active management approach, a portfolio manager constructs a strategy to beat the market and he has to select securities for the portfolio. In practice, the passive approach is implemented with index funds, i.e. funds that replicate a market index, whether actively managed funds will not track an index; they try to beat the market by doing particular investment strategies. The active approach relies on the skills of the portfolio managers show for identifying promising investment opportunities.
The novelty with smart beta funds is that the weighting scheme does not depend on price. Logically, a weighting scheme that is not correlated with price would not be really impacted by fluctuations in market sentiment, and its performance is enhanced. Thus, the idea of weights uncorrelated with prices is attractive to investors concerned about the effects of market fads.
Both Passive and Active
Smart beta funds can be compared to passive investing because, like index funds, they do not require the portfolio manager to forecast returns. They involve lower fees for investors and are less costly to manage. But smart beta investing can also be compared to active investing because the portfolio choice requires many active decisions such as the choice of the weighting scheme, rule selection or sources, etc.
Different Weighting Schemes
In fundamental weighting schemes, funds weigh stocks using fundamental variables such as sales, operating cash flow and earnings. Thus, stocks from companies with good fundamental metrics are then overweighted in the portfolio;
In the factor weighting schemes, market-cap weighting is replaced by a weighting scheme that emphasizes certain factors that have performed well historically, such as value, size, dividend yield or momentum. These funds can target either one factor alone (single factor) or they can target several factors at the same time (multifactor).
Another popular risk-weighting scheme is risk-parity, or inverse volatility: Each asset is weighted in inverse proportion to its volatility. This also means that correlation is absent from the weighting scheme. The strategy penalizes high-volatility assets, even if they are negatively correlated to other assets. The only thing weighting schemes have in common is that they do not rely on market capitalization.
The only thing weighting schemes have in common is that they do not rely on market capitalization.
Beta Funds: A Smart Investment After All?
As with any financial investment, smart beta funds present risks. For instance, smart beta funds are likely to underperform because returns are time-varying, they will need to regularly rebalance the portfolio to adjust to factor exposure, while the market capitalization scheme automatically rebalances. This implies higher turnover than common index funds, and therefore higher transaction costs and lower returns. While in market capitalization weighting, there might be concentration on popular stocks, in smart beta approach, some weighting schemes might concentrate in some industries or in illiquid assets, which increases the risk. Nowadays because of the soaring popularity of the smart beta approach, many of the stocks that are targeted are expensive, which causes lower returns.