What are Smart-Beta Funds?

This article will explain the function of Smart-Beta Funds as well as their unique advantages and disadvantages for investors and their fund strategies.

Let’s break down the term “Smart-Beta fund”. We’ll start with the term Smart-Beta. Smart Beta defines a set of investment strategies that emphasize using alternative index construction rules as opposed to traditional market capitalization based-indices. This means that instead of using the top 500 companies with the highest market capitalization to construct an index, like the S&P 500, we select a group of stocks based on a different underlying factor, such as highest annual dividend yield or low stock volatility or a combination of these factors. Companies are the valued and weighted based on this alternative factor(s). These alternative strategies allow investors to mitigate market inefficiencies caused by market-capitalization-weighted benchmarks.

More specifically, the term “Beta” measures the volatility of a security or fund compared to the overall volatility of the market. The stock market, usually referring to the S&P 500, has a Beta of 1, so if a security has a beta of 1.5, it is 50% more volatile than the market. So you can think of smart-beta as being alternative methods for measuring and constructing risk.

Now, the term fund means that this group of stocks is packaged into an Exchange Traded Fund (ETF). An ETF is a marketable security that trades like a common stock on an exchange. This means that its price increases and decreases throughout the day as investors buy and sell various ETFs. Some of the advantages of an ETF are that they are typically less expensive than a mutual fund and that they provide investors with the ability to mitigate risk and diversify their portfolio. If one stock experiences a significant fall, it will only have a mild effect on the fund as opposed to if it were a stand-alone investment.

Investors who implement smart-beta strategies are passively following their funds, meaning that these investors will hold on to their smart-beta funds long-term while monitoring their developments. Since investors assume the role of passive managers, they are able to avoid the high fees of active managers. This gives investors a more feasible method of obtaining alpha, the active return on an investment against the market index.

The overall advantages of Smart-Beta Funds are:

  • Their cost-effectiveness when compared with both mutual funds and active managers’ fees
  • Flexibility that allows managers to more feasibly obtain alpha, diversify their portfolios, and reduce risk
  • Ability to experience higher returns than typical index funds while using a different underlying factor

While these are very attractive features of the smart-beta fund, there are also some significant drawbacks.

Since smart-beta funds are intended to be long-term investments, it is difficult to predict how a particular factor will perform in more than a year from now. A basic example would be that in year 1 many firms decide to pay out significant dividends. However, in year 2, 3, and 4, firms may decide not to pay out dividends and reinvest that capital back into the company. Because it can be difficult to predict outcomes or returns a year from now, investors and fund managers may experience a higher level of portfolio turnover and rebalancing costs as they attempt to retool and perfect their funds with the appropriate combination of underlying factors.

Additionally, since Smart-Beta funds are created using alternative index construction techniques, they are accompanied by different risks. This means that while investors may be using smart-beta funds to mitigate the risks associated with traditional index-constructed funds, they often assume additional risks through their multiple underlying factors. For example, a fund may comprise of energy stocks that have high-profit margins in years past. However, because of changing trends in the market, agreements with OPEC, or U.S. shale oil production, these margins could diminish over time, which causes investors’ funds to underperform.

Overall, there are numerous risks and benefits for considering smart-beta funds in addition to the ones provided here. While investors may be avoiding certain risks, they are also signing up for newer risks that have not been taken on previously. However, this can be mitigated with due diligence research and a proper examination of how other smart-beta funds have performed in the past. Likewise, the risk of measuring the long-term performance of funds is common in the passive investment management field. Investors will be able to overcome this through experience and eventually be able to obtain economies of scale through further development with their smart-beta portfolios.

My investor advice would be to explore opportunities in smart-beta funds while doing your due diligence to ensure that the factors you’re selecting will provide you with your desired returns and investment goals.

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