Top 5 Smart Beta FAQs

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Includes: MTUM, QUAL, SIZE, USMV, VLUE
by: Sara Shores, CFA

Much has been written about smart beta strategies, and it can get confusing for investors. Answers to these frequently asked questions here could help.

Since my first smart beta blog post in 2014, assets in those strategies have grown exponentially (Source: BlackRock Global Business Intelligence), as investors catch on to smart beta's potential to enhance returns and reduce risk. But sometimes all the information out there can be overwhelming. To help investors cut through the noise, we are answering some frequently asked questions regarding smart beta.

Why use smart beta in a portfolio?

Traditional active and index funds can help investors achieve their financial goals, but they don't have to be the only solutions. Smart beta strategies capture the power of factors - broad and historically rewarded drivers of returns such as value (buying cheap) and momentum (trending upward) - to seek higher returns or lower risk. Long embedded within leading active fund managers, factors can now be accessed through cost effective and efficient smart beta exchange-traded funds (ETFs).

What type of strategies are available?

We think about the category in two broad areas:

Single-factor strategies seek to capture individually rewarded style factors. Value, size, quality and momentum strategies can help investors outperform the market while minimum volatility strategies seek to reduce risk. Because the performance of each factor may vary in different economic cycles, single-factor strategies can be used to express tactical portfolio tilts.

Multifactor strategies combine factors into one holistic, broadly diversified strategy that can potentially outperform the broad market.

Where does smart beta fit with my other investments?

I'm often asked about where to add smart beta strategies. Should they replace or complement traditional index or active strategies? The answer will depend on an investor's goals and circumstances.

I've seen investors replace traditional index allocations with smart beta strategies in seeking to improve returns, reduce risk or enhance diversification relative to market-cap-weighted indexes.

Some investors use smart beta strategies to replace active strategies in seeking to reduce the number of holdings and related costs, as well as to help improve the consistency of performance.

Other investors holding a combination of active strategies and traditional index strategies opt to complement with smart beta, which may help to reduce risk and costs, while improving return potential.

How do I get started with smart beta?

An easy way to add smart beta to a portfolio is through a multifactor strategy. Depending on the market environment, one factor may zig while the others zag. Value, momentum, quality and size have historically low return correlations, so a multifactor smart beta portfolio can potentially benefit in a variety of market conditions and may lead to more consistent long-term results.

Some investors prefer to add smart beta strategies that target one factor as a way to complement existing portfolio holdings. Single-factor ETFs can be used tactically to express views. Take quality, which can be used tactically late in the economic cycle when earnings are typically deteriorating and financially healthy stocks tend to be in particular favor.

Single-factor strategies may also enhance diversification. In a portfolio tilted toward high-growth stocks with less stable balance sheets, a quality factor ETF can be used to seek/achieve diversified exposure to financially healthy stocks.

Whether a single- or multi-factor approach, there are many different ways to implement smart beta strategies and bring to life the intuitive and longstanding investment ideas that have historically driven performance.

How should I choose a smart beta strategy?

Not all smart beta strategies are created equal. Even among strategies that target the same factor, outcomes can differ substantially due to varying methodologies and portfolio construction rules. We find that setting clear objectives helps sort through the many options: are you seeking outperformance or risk reduction, and what factor exposures will drive those results? The best forms of smart beta are deliberate and transparent in the exposures they deliver, making it easy for investors to determine what's under the hood.

Perhaps more critical is picking the right provider. Smart beta managers should be investment partners with expertise in implementation, including a critical evaluation of risk, return and costs. Most smart beta strategies have higher turnover than traditional market cap-weighted indexes, and slightly less advantageous liquidity. Without a skilled portfolio management team in place, transaction costs and tracking error may quickly begin to erode the potential benefits of a smart beta strategy.

Have more questions?

Ask away in the comments below and I’ll try to answer them in my upcoming posts. Investors looking to access smart beta strategies for U.S. equities may want to consider the iShares Edge MSCI USA Value Factor ETF (BATS:VLUE), iShares Edge MSCI USA Momentum Factor ETF (BATS:MTUM), iShares Edge MSCI USA Quality Factor ETF (BATS:QUAL), iShares Edge MSCI USA Size Factor ETF (NYSEARCA:SIZE) and iShares Edge MSCI Min Vol USA ETF (BATS:USMV).

This post originally appeared on the BlackRock Blog.