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INVESTING EXPLAINED: what you need to know about smart beta, a strategy that combines active and passive investing, focusing on the best of both
In this series, we break through the jargon and explain a popular investment term or theme. Here it is smart beta funds.
So what is smart beta?
A strategy that can be seen as a mix of active and passive investing, focusing on the best of both.
The goal is to beat the performance of a stock index, with decent returns and diversification.
What is smart beta?: A strategy that can be seen as a mix of active and passive investing, focusing on the best of both
The fashion for smart beta – also known as factor investing – peaked in the middle of the last decade.
It’s been less fashionable lately, probably because there’s no convincing evidence yet that the strategy is reliable.
Yes. Smart beta may not be so smart.
Who invented this?
The American economist Harry Markowitz, a professor of finance at the Rady School of Management at the University of California, devised the framework in the early 1950s.
Today, managers use a wide variety of approaches in pursuit of the goal.
But at their heart, equations are named after Greek letters that calculate a stock’s excess return and volatility.
A stock’s alpha — named after the first letter of the Greek alphabet and the holy grail for all active fund managers — is a measure of how the stock has performed against a stock index. The higher the number, the greater the out-performance.
A stock’s beta, named after the second letter of the alphabet, is an indication of its sensitivity to market movements, also measured by an index. A stock with a beta of 1 is expected to move with the market. A stock with a higher score will be more volatile and may offer better returns, but with added risk.
How does a smart beta fund work?
An index fund or Exchange Traded Fund (ETF) is “weighted” by the market capitalizations of each of the companies in the index.
Companies with the largest market caps have the heaviest weightings, meaning they can dominate the fund and crowd out the smaller companies.
A smart beta fund should avoid this overrepresentation as it is built from a modified version of the index to produce a unique basket of shares.
The focus can be low risk, momentum, quality, value or something else.
How popular are these funds?
Investors in the US, UK and elsewhere put billions into smart beta in response to major marketing campaigns.
The message was that you can avoid the costs on active, human-managed funds, while getting better returns than those of ‘passive’ or tracker funds.
These funds, which mimic the movements of a particular index, rely on stock selection computer programs.
Has smart beta been a way to make a lot of money?
Not that far. Some experts attribute this to the amount of money flowing into these funds, reducing their competitive advantage.
It seems that if you want diversification, there is no easy answer.
A mix of active and tracker funds and a balanced portfolio can still be the most viable option.