Much as people acquire wisdom as they age, investment strategies and products evolve as years and markets pass. For example, “smart beta” indexes — which weight companies according to criteria other than market capitalization — have become much more sophisticated over the past decade. Today’s smart beta indices are infused with heightened capabilities for potentially delivering higher risk-adjusted returns than their market-cap-weighted counterparts over the long term.
What Is Smart Beta?
“Smart beta is a rather elusive term in modern finance,” notes the online Financial Times Lexicon tool. “It lacks a strict definition and is also sometimes known as advanced beta, alternative beta or strategic beta.”
The broad definition and terminology for smart beta can confuse investors and their financial advisors. Although smart beta strategies fall under an expansive umbrella, they share the same basic goal — to correct common flaws in market-cap-weighted indexes so that investors can better capture long-term, risk-adjusted outperformance.
Market-cap-weighted indexes tend to accumulate outsize exposure to the largest market cap and growth companies, which are historically not the most advantageous factors. This concentration can be dangerous for investors in the event of a sudden downturn. Smart beta indexes attempt to provide improved diversification by utilizing an alternative weighting methodology or diversifying exposure towards more advantageous factors.
It can come down to the difference between proper market measurement and market outperformance. Market-cap-weighted indexes are traditionally designed to measure markets, but no specific tools are used to maximize the performance. On the other hand, smart beta indexes are specifically designed with the objective of maximizing an exposure’s risk/return profile.
In 2008, many investors learned the hard way that market-cap-weighted indexes and Modern Portfolio Theory asset allocations may not provide diversification and protection in extreme market conditions. In the years since, exchange-traded funds (ETFs) tracking smart beta indexes have become popular among investors seeking alternatives to traditional indexing strategies. More than 350 smart beta ETFs, collectively totaling over $230 billion in assets under management (AUM), were available in the U.S. at the end of 2014, compared with 212 smart beta ETFs with $64.8 billion in AUM at year-end 2010, according to Bloomberg.
Smart Beta 2.0
The simplest smart beta indexes (smart beta 1.0) either weight companies equally or focus on a single factor. However, more advanced indexes created in recent years take smart beta to the next level by incorporating both multiple factors and multiple weighting strategies (smart beta 2.0). These indexes provide opportunities to maximize diversification and proactively maneuver holdings ahead of market developments.
Multi-factor, multi-strategy ETFs generally have higher expenses than ETFs tracking less complex smart beta indexes, but the former may be able to justify their higher fees by offering the potential for better after-fee performance. When seeking potential “smart beta 2.0” products, make sure long-term performance analysis from respected academics and economists forms the basis of their indexes.