Smart Beta

What Is Smart Beta?

Smart beta investing combines the benefits of passive investing and the advantages of active investing strategies.

The goal of smart beta is to obtain alpha, lower risk or increase diversification at a cost lower than traditional active management and insignificantly higher than straight index investing. It seeks the best construction of an optimally diversified portfolio. In effect, smart beta is a combination of efficient-market hypothesis and value investing. The smart beta investment approach applies to popular asset classes, like equities, fixed income, commodities and multi-asset classes. Economist Harry Markowitz first theorized smart Beta by means of his work on modern portfolio theory.

Smart Beta Explained

Smart beta defines a set of investment strategies that emphasize the use of alternative index construction rules to traditional market capitalization- based indices. Smart beta emphasizes capturing investment factors or market inefficiencies in a rules-based and transparent way. The increased popularity of smart beta is linked to a desire for portfolio risk management and diversification along factor dimensions, as well as seeking to enhance risk-adjusted returns above cap-weighted indices.

Smart beta strategies seek to passively follow indices, while additionally considering alternative weighting schemes, for example, volatility, liquidity, quality, value, size and momentum. That is because smart beta strategies are implemented like typical index strategies in that the index rules are set and transparent. These funds don't follow standard indices, for example, the S&P 500 or the Nasdaq 100 Index, but instead, center around areas of the market that offer an opportunity for exploitation.

Selecting Smart Beta Strategies

There is no single approach to developing a smart beta investment strategy, as the goals for investors can be different based on their needs, however some managers are prescriptive in identifying smart beta ideas that are value-creating and economically intuitive. Equity smart beta seeks to address inefficiencies created by market-capitalization-weighted benchmarks. Funds might take a thematic approach to manage this risk by zeroing in on mispricing created by investors seeking short-term gains, for example.

Managers may likewise choose to create or follow an index that weights investments as per fundamentals, for example, earnings or book value, rather than market capitalization.

Alternatively, managers might use a risk-weighted approach to smart beta that involves the establishment of an index based upon assumptions of future volatility. For instance, this might involve an analysis of historical performance and the correlation between an investment's risk relative to its return. The manager must evaluate the number of assumptions they that will build into the index and can approach the index by expecting a combination of different correlations.

Smart Beta Popularity

Albeit smart beta funds typically draw in higher fees than their vanilla counterparts, they continue to remain popular with investors. As of February 2019, 77 new smart-beta exchange-traded funds (ETFs) launched, which accounts for about 33% of all ETFs that came to market in the past year, as per FactSet data as reported by ETF.com. Smart beta funds likewise attracted a more critical increase in assets under management (AUM) over the period, developing at 10.9% compared to 4.3% for vanilla funds. Altogether, smart beta funds command $880 billion altogether cumulative assets, up from $616 billion out of 2016.

Example of Smart Beta Funds

The following three ETFs each use a different smart beta strategy seeking value, growth and dividend appreciation, respectively:

The Vanguard Value Index Fund ETF Shares ETF (VTV) tracks the CRSP US Large Cap Value Index. Its benchmark determines value utilizing several fundamental ratios including price-to-book (P/B), forward price-to-earnings (forward P/E), historical P/E, dividend-to-endlessly price to-sales. The fund has $77.25 billion in AUM as of April 2019.

With net assets of $42.73 billion as of April 2019, the iShares Russell 1000 Growth ETF (IWF) seeks to provide comparable returns to the Russell 1000\u00ae Growth Index. The underlying selects components based on three fundamental factors: price-to-book, medium-term growth forecasts, and sales per share growth.

The Vanguard Dividend Appreciation Index Fund ETF Shares (VIG) plans to return comparative investment results to the Nasdaq US Dividend Achievers Select Index. The fund selects firms that have increased their dividend payments for the past 10 years and market-cap-weights its holdings. As of April 2019, VIG has AUM of $40.94 billion.

Features

• In 2019, smart beta funds command $880 billion altogether cumulative assets.
• Smart beta strategies might use alternative weighting schemes like volatility, liquidity, quality, value, size and momentum.
• Smart beta seeks to combine the benefits of passive investing and the advantages of active investing strategies.
• Smart beta emphasizes capturing investment factors or market inefficiencies in a rules-based and transparent way.
• Smart beta uses alternative index construction rules to traditional market capitalization-based indices.