Smart Beta Investing: A Powerful Strategy for Optimal Portfolio Management
Smart beta investing merges the ease of passive investing with the precision and potential rewards of active investing strategies.
The primary goal of smart beta is to achieve alpha, reduce risk, or enhance diversification with minimal costs slightly higher than straight index tracking but significantly lower than active management. This approach aims to build the most efficiently diversified portfolio, combining concepts from the efficient-market hypothesis and value investing. Smart beta can be applied across various asset classes, including equities, fixed income, commodities, and multi-asset classes.
Smart Beta Explained
Smart beta encompasses investment strategies that use alternative, non-traditional index construction rules rather than the conventional market capitalization-based indices. These strategies focus on capturing investment factors or market inefficiencies transparently and systematically. As interest grows in risk management and adding diversity through different factor dimensions, smart beta has gained popularity in enhancing risk-adjusted returns.
Smart beta strategies passively follow indices but incorporate alternative weighting schemes such as volatility, liquidity, quality, value, size, and momentum. Unlike standard indices like the S&P 500 or Nasdaq 100, smart beta funds target market areas that offer exploitable opportunities.
Key Takeaways
- Smart beta blends the benefits of passive and active investing strategies.
- It employs alternative index construction rules beyond traditional market-cap-based indices.
- It captures investment factors or market inefficiencies in a rigorous and transparent manner.
- Strategies may use alternative weighting schemes such as volatility, liquidity, quality, value, size, and momentum.
- As of 2019, smart beta funds command $880 billion in total cumulative assets.
Exploring Smart Beta Strategies
There is no one-size-fits-all approach to developing a smart beta strategy, as investor goals vary. Some managers focus on value creation and economic intuition. Equity smart beta aims to address the inefficiencies created by market-cap-weighted benchmarks by occasionally opting for thematic strategies that target mispricing due to short-term investor behaviors.
Managers might create indices weighted by fundamentals like earnings or book value rather than market cap. Others may adopt a risk-weighted approach based on anticipated future volatility, analyzing historical performance and correlation between an investment’s risk and potential return.
The Popularity of Smart Beta
While smart beta funds generally come with higher fees than more straightforward index funds, their popularity remains robust. As of February 2019, 77 new smart-beta ETFs were launched, which represented about a third of all newly launched ETFs. Smart beta funds are also capturing higher assets under management growth, outpacing their simpler counterparts, reaching $880 billion in assets by early 2019.
Examples of Smart Beta Funds
Here are a few notable examples of smart beta ETFs, each utilizing different strategies to achieve various objectives like value, growth, and dividend appreciation:
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Vanguard Value Index Fund ETF Shares (VTV) The VTV tracks the CRSP US Large Cap Value Index, using fundamental ratios such as price-to-book (P/B), forward price-to-earnings (P/E), historical P/E, dividend-to-price, and price-to-sales to determine value. It holds $77.25 billion in AUM as of April 2019.
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iShares Russell 1000 Growth ETF (IWF) With $42.73 billion in assets as of April 2019, IWF seeks to mirror returns of the Russell 1000® Growth Index by selecting components based on price-to-book ratios, medium-term growth forecasts, and sales-per-share growth.
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Vanguard Dividend Appreciation Index Fund ETF Shares (VIG) VIG targets investment results similar to the Nasdaq US Dividend Achievers Select Index, selecting firms that have consistently increased their dividend payments for the past ten years. The fund has $40.94 billion in AUM as of April 2019.
Related Terms: passive investing, active investing, risk-adjusted returns, market capitalization, ETF (Exchange Traded Funds).
