In recent years, investing publications have been full of articles exploring the promise of smart beta investment strategies.
But what’s exactly so smart about smart beta?
Continue Reading Below
Smart beta enthusiasts and the investment firms that offer these kind of investment products say the approach potentially offers investors robust returns with lower risk and less correlation with other investments.
Smart beta ETFs are carefully constructed indexes that rank stocks by traits other than their market value, the standard methodology employed by traditional benchmarks, such as the Standard & Poor’s 500.
Instead, these products focus on “factors,” such as growth, value, dividends, volatility or other financial metrics that offer the possibility of market-beating performance and reduced portfolio risk.
In traditional fund products based on a market-weighted index, large-cap stocks can distort the performance of the entire index.
Securities with inflated prices can balloon to take up a larger and larger share of an index, like technology stocks during the late-1990s dot com bubble or banks prior to the 2008 crisis.
Should a sector boom turn into a bust, index funds weighted by market cap can deliver an outsized hit to investors’ portfolios.
Some argue that this approach of blindly weighting companies solely according to their market value is not so smart. In fact, it’s a recipe for sub-optimal returns.
In other words, there’s a risk of overweighting overvalued stocks and underweighting undervalued ones.
So-called “smart beta” index funds, on the other hand, aim to combine elements of passive index-tracking and active fund management to deliver the best of both worlds: transparent construction, diversification, and possibly enhanced returns—all at a relatively low cost.
Many alternatively weighted index strategies are new products with little in the way of a track record. So smart beta ETF providers often do back-testing by applying a mathematical model to historical market data.
Such data-crunching can provide useful insights into the potential strengths of a smart beta strategy. Yet, keep in mind that it doesn’t predict or guarantee future performance.
The same holds true of academic research some financial companies roll out in their marketing materials to promote their products.
Smart beta strategies are typically less expensive than actively-managed funds. That said, they generally cost more than passive, market-cap-weighted indices.
Smart beta indices are rule-based and rebalance their holdings on a regular basis to keep their underlying strategy on track. This turnover can increase investor costs.
Fees and commissions, even modest ones, eat into returns. So get an accurate read on the fee and commissions structure from the provider.
Finally, some smart beta indices are pretty straightforward, but others are based on complex methodologies.
Read the prospectus, check out the provider’s website and consult an investment professional, if need be, to make sure you’re adequately informed before diving in.
The post What’s smart about smart beta? appeared first on Smarter InvestingCovestor Ltd. is a registered investment advisor. Covestor licenses investment strategies from its Model Managers to establish investment models. The commentary here is provided as general and impersonal information and should not be construed as recommendations or advice. Information from Model Managers and third-party sources deemed to be reliable but not guaranteed. Past performance is no guarantee of future results. Transaction histories for Covestor models available upon request. Additional important disclosures available at http://site.covestor.com/help/disclosures.