Smart Beta Funds, Smart Beta Indices and Smart Beta Investment Strategies?
By contributing columnist, Hank Coleman
Finding a system that beats the stock market is akin to the search for the Holy Grail. It’s a glorious and righteous quest that has gone on for centuries and will continue to do so long after we’re all gone. That’s where smart beta funds and indices come in to play in the stock market.
Smart beta funds look to tweak index fund investing to the next level by strategically weighting stocks inside the funds based on objective factors. And, typically robo-advisors choose the investments within the fund and manage its smart beta investment strategy based on a set of factors or criteria.
What Is the Beta in Smart Beta?
In stock market lingo, an investment’s beta measures its amount of volatility when compared to the market as a whole, typically the S&P 500 index. All types of investment ranging from individual stocks, bonds, mutual funds, and the like have a beta.
Betas typically fall within the range of zero to two. The S&P 500 index is the barometer for the overall stock market and has a beta of one. Investments and individual stocks are ranked by how much their prices move or deviate from the standard beta of one.
A fund with a beta of one typically advances or declines in value in lockstep with the overall stock market.
A stock or mutual fund with a beta of two is expected to behave like this:
When the market goes up 10% and the fund with a beta of two (and a correlation of 0.95) might increase 21%. If the S&P dropped 10%, this fund might decline 19%.
You don’t have to express beta in whole numbers either. A stock can have a beta of 1.3, for example, and that means it theoretically has 30% more volatile than the overall stock market. Equally, if a mutual fund or exchange traded fund (ETF) has a beta is 0.75, it is theoretically 25% less volatile than the overall stock market.
A fund or financial asset with a negative beta should decline in value when the market rises and vice versa. Adding a smart beta fund could be a good addition to diversify an investment portfolio.
By checking out a fund’s beta you can gain insight into how your investments might perform, in comparison with the returns of the overall market.
What are Smart Beta Indices?
Typically, market capitalization,or market cap, rules the day in passive index fund investing. Market capitalization is calculated by multiplying a company’s share price by number of shares outstanding. The resulting dollar value is a way of measuring the size of a company.
Traditional indexes weight the stock holdings within the index based upon their market cap. So Apple (AAPL), with a market cap of 815.39 B would have a greater weight in an S&P 500 index fund than Alaska Air Group (ALK), with a market cap of 10.61 B.
Companies that typically have $10 billion or more in market capitalization are considered large cap stocks. Mid cap companies are between $2 billion and $10 billion in market capitalization. And, small cap companies are typically between $300 million and $2 billion.
Smart beta funds are based on smart beta indices that use an alternative method to group companies. Instead of grouping stocks within the smart beta index according to market cap, they might weight them based on other factors such as:
- Growth rate
- Cash flow
- Book value
- Low volatility
- and a host of other metrics
With smart beta funds, computer algorithms or robo-advisors weight stocks by objective rules or factors to screen which stocks to purchase in an effort to outpace a straight index over extended periods of time.
Smart beta mutual funds and exchange-traded funds review academic studies to see which rules or factors have correlated to stock market prices. The smart beta funds goal is to beat the market-cap weighted indexes.
Towers Watson, the professional services firm, created the term Smart beta funds, but investors have used beta as a trading strategy since the 1970s. The first smart beta ETF was created in 2003. Smart beta funds eliminate the size bias in investing in favor of an objective rules-based methodology to find stocks poised to beat the stock market.
What Is a Smart Beta Investment Strategy and Can it Beat the Market?
A smart beta investment strategy seeks to beat the traditional stock market indices by purposefully weighting, rebalancing and choosing the stocks of companies based on objective factors. The smart beta approach seeks to improve on the passive lazy investment strategy.
Investors look to smart beta investments to outperform the market.
As of September 2015, investors have over 450 smart beta investment choices between mutual funds, index funds, and ETFs run by robo-advisors and traditional financial advisory firms alike. These smart beta funds manage over $510 billion in assets.
Check out Personal Capital’s Sector Weight Smart Beta Approach
These advisors use factors such as low volatility, momentum, quality, growth, size, dividend growth, sales, cash flow, book value, share buyback, contrarian, and other characteristics to determine their fund’s underlying holdings. While smart beta strategies seek to outperform benchmark indexes for investors’ portfolios, fund managers can’t assure investors of gains that beat the market.
An Investco study, found that smart beta funds can beat the returns of market weight indexes. The investment firm examined data over a 24 year period from 1991 to 2015 and the results were that specific smart beta ETFs outperformed the S&P 500 index. The study looked at five smart beta investment strategy factors: quality, value, small tilt, momentum and low volatility.
Not all smart beta strategies are alike. There are a lot of different methodologies available. Each one has advantages and drawbacks. Like all investments, it’s important for investors to carefully examine the smart beta mutual fund, ETF, or index fund they are investing in. You must understand which single or multiple factors each investment fund uses.
Should I Try a Smart Beta Investment Strategy?
Some robo-advisors and traditional advisory firms use computer algorithms to create smart beta funds. These smart beta funds and approaches don’t weight stocks or funds by market cap but by objective factors or a distinct set of rules by which to screen stocks for purchase. They create these smart beta funds to try and outpace an index (primarily the stock market as a whole) over extended periods of time.
If you’re looking for an approach to beat the market, you might investigate a smart beta strategy. Smart beta funds can diversify your portfolio and potentially counteract some stock market volatility.
When the smart beta strategy strives for an inverse relationship between the smart beta funds and the market, you might gain an advantage when the market declines. And this bull market will turn around eventually. Ultimately, you should always weigh your their investment objectives and understand your time horizon when putting money into the markets.
Hank Coleman is a personal finance expert who writes extensively about investing and retirement planning on this blog, Money Q&A, which is dedicated to helping answer its readers’ tough money questions such as how to find the best return on investment. Hank has a Masters degree in finance and a graduate certificate in personal financial planning. You can follow him on Twitter at @MoneyQandA.