By Columbia Threadneedle Investment Team
1. Smart beta funds were created as a way to improve upon index investing. Most popular indexes such as the S&P 500 track many securities but don't treat them all the same way. Many indexes select and weight individual securities based on size or market capitalization. The biggest constituents tend to dominate the index and have the greatest influence on performance, while the smaller constituents contribute less to overall returns. Some would argue that this is not the most efficient way to invest and leads to inferior performance over time.
Smart beta funds evolved in response to this investor concern. They track indexes that deviate from standard indexes in security selection and weighting. Some smart beta indexes simply allow each constituent to be weighted equally. Others employ novel security selection criteria and weighting methods to give increased emphasis to one or more "factors" such as value, momentum, lower volatility or quality - characteristics of securities that some believe are able to generate superior performance over time than market capitalization-weighted indexes.
2. Smart beta is not a new concept. Institutional investors have been studying and using smart beta concepts for decades. Academic research from the 1970s through the 1990s looked into the impact of investing factors such as value, quality, low volatility, size and momentum. Those studies helped advance mutual funds specializing in specific factors and, eventually, smart beta ETFs. "Smart" refers to the use of those factors versus following an index's market-cap allocations. "Beta" is a measure that indicates the degree to which a portfolio is expected to rise or fall compared to the market. Today, over 950 smart beta ETFS invest more than $478 billion for shareholders.1
3. Smart beta funds give investors many options. These funds track custom indexes that deviate from market-cap-weighted indexes. They are considered "rules-based" funds because they establish a set of rules to determine from the start which securities will be selected and how they will be weighted in the underlying index. The smart beta funds passively replicate these indexes. There are no other subjective considerations that alter the construction of the portfolio. The rules are the rules.
Equal weighting is the simplest alternative. But many weight their portfolios based on metrics such as company earnings, dividends or cash flow. Some build indexes with the aim of either lowering volatility or capturing price momentum. These are all considered single factor approaches.
Multi-factor smart beta funds attempt to improve upon single-factor products by simultaneously targeting multiple factors such as earnings, dividends and cash flows. The rationale behind this approach is that a diversified exposure to multiple factors should generate better investment outcomes over time than exposure to a single factor that could experience sustained periods of underperformance.
4. Smart beta strategies work with fixed-income investments as well as stocks. Smart beta funds that invest in fixed-income securities employ the same fundamental strategy, trying to build a better product around a better-designed index. Traditional fixed-income indexes tend to overweight the biggest borrowers and fail to fully consider credit quality. Many smart beta funds that invest in fixed-income securities try to improve upon interest rate sensitivity or credit risk for investors.
5. While smart beta funds aren't actively managed, they aren't entirely passive either. Traditional passive indexes do not provide a "view" on investment attractiveness, but rather attempt to provide clients with a broader market representation. Index funds that track them can truly be called "passive."
Smart beta funds are active in the sense that they portray a view for improving performance by enhancing certain features such as dividend income, quality, value, smaller size (such as the equal-weighted index), lower volatility, etc. They implement this active view by customizing the selection and weighting the securities in the underlying index. Also, they periodically rebalance these indexes to reflect the changing relative attractiveness of individual stocks and bonds.
But unlike actively managed funds, smart beta funds are bound by strict rules from the start and typically don't have any discretion to override individual security selection weighting. Actively managed funds trade securities regularly and make discretionary investment decisions to produce superior returns or risk outcomes. While active managers may work with goals or guidelines, most trade securities every day without precise rules that dictate every decision.
6. Management fees for US-based smart beta funds tend to be competitive with those for passive index-based exchange traded funds and considerably less expensive than actively managed mutual funds. Fees charged by investment funds vary and are always subject to change based on competition and other factors. But the weighted average fee for all US smart beta products was 33 basis points (bps) as of June 30, 2015,compared with a weighted average of 29 bps for all other exchange traded products, according to Morningstar. The weighted average fee gap was narrower for stock funds than fixed income funds, Morningstar found. On average, fees for actively managed stock mutual funds cost 84 bps and those for actively managed bond funds cost 60 bps in 2015, according to the Investment Company Institute.
7. The smart beta movement has some critics. Some believe that the growing popularity of smart beta products may be a problem for investors who buy them. They think the most popular strategies can create demand that drives up market prices and makes investment goals harder to reach. Many smart beta funds may focus on priorities popular across the entire market at a given time, such as dividends or low volatility. But new smart beta funds that choose to include more features could lead to greater investment diversification and less crowding among securities that score highest when measured by any single factor.
Some critics also question whether smart beta funds can outperform passive index investments the way numbers suggest. Many smart beta funds are relatively new and rely on historical backtesting to generate theoretical past returns based on the prices of securities they would have owned at the time. Critics say that this process is susceptible to statistical cherry-picking and often fails to consider real-world complications, such as higher than expected trading costs at times.
8. Some financial advisors see smart beta ETFs as an investment option in much the same way they view actively managed funds. Advisors use smart beta ETFs for many reasons but are most interested in protecting portfolios when markets go down, controlling volatility and trying to generate market-beating returns, according to a recent survey by FTSE Russell and Greenwald & Associates.2 Financial advisors who participated in the survey said they most often favored smart beta ETFs focused on dividend-oriented and "high quality" portfolios.
Smart beta ETFs offer investors a broad pallet of choices to build portfolios, but it's very important to understand how they work and how they can be used. Like all investments, smart beta funds should be evaluated based on an investor's specific financial needs, objectives, goals, time horizon and risk tolerance.
- Morningstar Manager Research, February 2016
- As of June 2015
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