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.

In addition, investors should investigate the turnover in prospective smart beta indexes. Frequent rebalancing can lead to higher trading costs and negative tax consequences for ETF investors, so make sure the index underlying a prospective smart beta ETF attempts to limit turnover. The combination of academically supported factors and strategies with quarterly rebalancing can lead to risk-adjusted outperformance afterfees for investors. For example, one of our firm’s ETFs — the ETFS Diversified-Factor U.S. Large Cap Index Fund (SBUS) — tracks a multi-factor, multi-strategy index developed by Scientific Beta (an affiliate of the EDHEC Business School).

Don’t Sweat Short-Term Results

Smart beta strategies can yield risk-adjusted outperformance for long-term investors, but like other long-term strategies, they may suffer short-term setbacks. For example, recent media coverage about smart beta highlighted the S&P 500’s outperformance of its equally weighted counterpart this summer. On July 20, according to Bloomberg data, the S&P 500 traded at its highest level compared to the S&P 500 Equal Weight Index since June 2013.

By nature, smart beta strategies require long time commitments. The idea of smart beta achieved widespread attention following the publication of Research Affiliates’ paper “Fundamental Indexation” in the March/April 2005 issue of Financial Analysts Journal. The study found that portfolios using fundamental metrics to weight companies outperformed the S&P 500 by an average of 1.97% per year, and did so with higher Sharpe ratios, between 1962 and 2004. The portfolios analyzed in the study experienced periods of underperformance during the expansive time frame, but on average, they still managed to obtain higher returns than the S&P 500—and with less volatility—for 43 consecutive years. Furthermore, the use of multiple, well-researched factors and weighting strategies are designed to make smart beta indexes less susceptible to short-term underperformance.

Smart Money Continues Migration to Smart Beta

Another reason not to be spooked by recent smart beta headlines is that these strategies retain the confidence of the institutional investment community. A Market Strategies International/Invesco PowerShares survey conducted in late 2014 found that 36% of institutional investors currently invest in smart beta ETFs, and 62% expect to increase their assets in smart beta ETFs over the next three years.

Institutional investors are also eager to take advantage of more sophisticated smart beta indexes. Multi-factor, multi-strategy indexes designed by Scientific Beta have accumulated over $8 billion in institutional assets as of the end of July.

To build on the potential benefits of smart beta to further increase diversification and risk-adjusted outperformance, investors and their advisors can follow the smart money to “smarter” smart beta ETFs. As long as proper due diligence is conducted on multi-factor, multi-strategy smart beta products, their heightened sophistication may position investors for improved overall risk adjusted performance.

An investor should consider the investment objectives, risks, charges and expenses of the ETFs carefully before investing. To obtain a prospectus containing this and other important information, call 1-212-918-4954 or 844-ETFS-BUY (844-383-7289) or visit www.etfsecurities.com. Read the prospectus carefully before investing.
 
There are risks associated with investing including possible loss of principal.
Diversification does not eliminate the risk of experiencing investment losses.
ALPS Distributors, Inc. is the distributor for the ETFS Trust.
Mike McGlone is a registered representative of ALPS Distributors, Inc.
For use with institutions only, not for use with retail investors.