Investors have poured more than $1 trillion into smart-beta funds, which continue to grow in popularity.
So what exactly is smart beta?
Smart beta can be described as an investing strategy that blends elements of both passive and active management.
Understanding Smart Beta
Passively managed funds aim to mimic the returns of a given index like the S&P 500, which tracks the performance of the stocks of the 500 leading companies in the United States. These funds generally invest in these stocks based on market capitalization. While this strategy provides simplicity and low costs, it could give greater weight to larger companies. This could in turn reduce diversification and increase risk.With actively managed funds, the fund managers actively buy and sell shares based on market conditions, research, and other data in an attempt to outperform a given benchmark or index. But studies have shown that actively managed funds often fail to beat their benchmarks and also rake in higher fees than their passively managed counterparts.
Smart beta lives somewhere in between.
Smart-beta funds also follow indexes. But instead of focusing on stocks exclusively based on market capitalization, these funds focus on specific factors that affect risk and return. With this rules-based approach, these factors can include value, quality, momentum, and low volatility.
But unlike actively managed funds which aim to outperform a specific benchmark, smart-beta funds are designed to align with a specific investing goal.
For example, risk-averse investors may want to pursue smart-beta funds that emphasize low-volatility or quality-focused strategies.
How Smart Beta Works
Smart-beta funds prioritize specific factors to meet certain objectives like maximizing growth or minimizing risk. Here are some of these key factors:- Momentum: This involves investing in stocks that have recently shown strong performance with the assumption that this trend would continue.
- Value: This factor focuses on stocks of companies deemed undervalued by the market as a whole.
- Quality: This emphasizes stocks of companies that have strong fundamentals like consistent earnings, strong balance sheets, and high profitability. It may involve analyzing metrics like price-to-earnings or price-to-book ratios.
- Low volatility: This focuses on stocks with less frequent price swings. Another way to measure volatility is to use “beta.” This measures a stock’s sensitivity to the movement of the overall stock market. A stock with a beta of 1.0 indicates it moves in lock step with the overall stock market. But if it’s more volatile than the overall market, it would have a beta higher than 1.0. For instance, if a stock has a beta of 1.2, it’s deemed 20 percent more volatile than the market. Say the S&P 500 increases by 10 percent. A stock with a beta of 1.2 is expected to increase by 12 percent. And if the index drops by 10 percent, the stock is expected to drop by 12 percent.
- Size: Smart beta can also consider market capitalization as a factor. It may focus on small-cap stocks with perceived high potential. Or it may steer toward large-cap stocks with established records of strong performance and dominance in the market.
Top Smart-Beta Exchange-Traded Funds (ETFs)
One of the easiest ways to get exposure to smart beta strategies is to invest in smart-beta ETFs. Here are some examples.- Vanguard Growth ETF (VUG)
- iShares Russell 1000 Growth ETF (IWF)
- Vanguard Dividend Appreciation ETF (VIG)
- Invesco S&P 500 Equal Weight ETF (RSP)
- Schwab U.S. Dividend Equity ETF (SCHD)
