Smart beta is an investment strategy that combines elements of passive index investing with elements of actively managed investing. The ultimate goal is to achieve better performance than the benchmark index while maintaining the low risk and low volatility often cited as key elements in index investing.
Definition and Examples of Smart Beta
Smart beta is an investment strategy that is considered a hybrid between passive index investing and active management aimed at achieving better performance than the benchmark index. Smart beta integrates the best aspects of passive index investing – low risk and low volatility – with the potential for better performance of actively managed funds but at lower costs.
How Does Smart Beta Work?
To understand the term “smart beta,” it is essential to review the meaning of beta as it applies to investing. Beta is a measure of a stock’s volatility in relation to the overall market (for example, the S&P 500 index). The beta of the S&P 500 is expressed as 1.0. If a stock has been more volatile than the S&P 500 in the past, its beta will be higher than 1.0.
For example, if a stock is 20% more volatile than the S&P 500, its beta would be 1.2. Any stock with a beta greater than 1.0 is considered more risky than the index, but it should also increase in value more than the index when the market is rising. If the S&P 500 rises by 10% over a certain period, the stock with a beta of 1.2 should increase by 12% during the same period. Conversely, stocks with a beta less than 1.0 carry less risk than the index but typically have lower returns.
Types of Smart Beta Strategies
Traditional market index funds and ETFs are “market capitalization-weighted compositions.” This means that the individual stocks within the fund are weighted based on the market value of each stock. A few stocks with large market values can represent a significant portion of the total index value.
Smart beta strategies aim to achieve better performance than traditional market indices while enhancing diversification and reducing risk by exploiting one or more performance factors other than market capitalization, such as momentum, earnings, volatility, or earnings growth. Multiple factors may be evenly weighted or layered.
Advantages and Disadvantages of Investing in Smart Beta
Advantages
- Multiple investment strategies
- Lower costs than actively managed mutual funds
Disadvantages
- Lack of evidence that it is a reliable strategy
- Can be complex
- Higher costs than index funds
Alpha vs. Beta
While beta measures volatility, alpha measures the difference between the expected return of a portfolio and its actual performance, adjusting for the level of risk as measured by beta. The baseline measure of alpha is zero.
A fund that returns 12% in a year when the S&P 500 returns 8% will have a positive alpha, while a fund with a return of less than 8% will have a negative alpha. Naturally, investors seek funds that achieve high alpha. However, less aggressive investors will balance alpha against beta.
As investors are always warned, past performance does not guarantee future results.
What Does This Mean for Investors?
Investors often seek ways to achieve better performance than the market in both good and bad times. Smart beta funds aim to outperform index funds in both bull and bear markets while providing lower volatility. However, investors should carefully research any smart beta investment vehicles they consider to ensure that the strategy aligns with their objectives and to assess the fund’s performance over various periods compared to index funds.
Conclusions
Main
- Smart beta funds are a hybrid between index funds and actively managed investment funds.
- They aim to achieve better performance than index funds by exploiting non-market-cap performance factors.
- Smart beta strategies can be used to invest in fixed income assets such as bonds in addition to equities.
- Smart beta funds generally have lower costs than actively managed funds but higher than index funds.
Source: https://www.thebalancemoney.com/what-is-smart-beta-5206921
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