What Is Smart Beta and How Does It Affect Your Investments?

Daniel Penzing
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First Things First: Defining “Alpha” and “Beta”

The word “beta” is derived from the Ancient Greek word for “bear” … can you guess where it came from?

No, not the animal. It comes from the shape of the letter “B.” Beta is used to designate a specific risk or volatility measure – not too much, but not too little. As you may have inferred from this definition, beta is a measure of a portfolio or a stock’s sensitivity to market returns.

Alpha, on the other hand, refers to the performance of a particular stock, stock portfolio, or other security relative to a benchmark index … the measure of its outperformance of a certain index.

Alpha and beta are often used to measure risk. However, not all securities have a beta of 1, which would mean they are perfectly correlated with the market. Some beta levels are below 1, while others are above 1, which means that the securities are negatively or positively correlated with the market.

What Is Smart Beta?

Straightforward investing based on market indexes has been the smart way to invest for decades. The indexes themselves are based on price rather than other considerations like dividends. Over the last couple of years, two concepts have started to emerge: “Smart Beta” and “Efficient Markets.”

Smart Beta is just what it seems: it’s all about taking the best parts of traditional investing and merging them with new approaches. The short-hand definition of smart beta is that it’s “an investment strategy that tries to incorporate the best of both passive fund management and active funds.”

Smart beta investing is a strategy that’s more concerned with how stocks are performing than with the overall market. Using factors like market cap and capitalization and applying formulas that include value, potential for growth, or perceived risk produces different investment strategies.

The basic idea of smart beta investing is to combine a traditional index approach with specific strategies tailored to the market. This has the potential to eliminate some of the weaknesses of basic market index investing. Think of it as the lazy man’s approach to investing: you get the best possibilities of a general-investing approach with the selectivity of tactical trading.

How Smart Beta Affects Investors

Investing your money seems next to impossible when there are so many things that can go wrong. That’s why the increasing number of new financial instruments makes it easier and easier to handle the risks of investing your money.

Smart Beta is now a major asset in any investor’s portfolio. Smart beta uses principles solely based on market data and statistics to reduce the risk involved in investing.

The process of Smart Beta is based on using indices that seek to distribute risks in a good ratio. The closest existing index is the Standard & Poor’s 500, but it sometimes has blind spots. For example, it has been found to have too much oil and technology, while lacking in others such as health care. In order to get rid of these kinds of risks, these sectors must be adjusted in the indices.

Smart Beta does not require professional stock picking skills. It is entirely based on market research, and there is now a wide range of smart beta products competing on the market.

What used to be the domain of only wealthy investors is now available to investors of all wealth levels.

Does Smart Beta Outperform the Market?

While it's unclear if smart beta will beat the market, what is clear is that it outperforms active managers.

If you're investing in a low-cost, diversified, tax efficient portfolio, then it is almost impossible to beat the market return unless you play the market yourself by having a concentrated investment over any short period of time.

In a previous article, I examined how the concept of beta shifted to mirror more of the strategy and an innovative way to manipulate the traditional concept of beta by effectively shifting the portfolio's position from passive to more active. While not presenting the concept of smart beta, the article does address the idea of active beta.

To briefly explain the difference, the term smart beta was created to describe a management-focused investment strategy that attempts to shift the portfolio away from a concentration on broad market exposure to a goal of capturing known market inefficiencies.

By collecting the top stocks of the index, for instance, an investment manager may believe they can capture the returns of the entire market by avoiding the parts or sectors that aren't performing, but without the standard deviation risk involved.

Over the past decade, active managers have been missing the mark in many different style categories, and smart beta can be attractive as a way to quickly and efficiently shift the portfolio away from the lagging style categories.

Which Robo Advisors Use Smart Beta?

There are many robo advisors that use Smart Beta index as investment strategy, including: Betterment, Wealthfront, Personal Capital, Acorns, and others.

Smart Beta, or intelligent beta, is a methodology of seeking investment returns that is based on selecting a portfolio of securities that are not included in mainstream index funds. The basic premise is that many traditional index funds have arbitrary rules (for example, market cap weights) that can lead to poor volatility levels and return potential.

The Smart Beta strategies involve applying rules to try to select the stocks that are most likely to provide the most return. This ultimately allows for better diversification of the securities and a portfolio likely to outperform the industry average.

Ultimately, the Smart Beta approach is targeted toward removing the randomness from the market, by trying to select companies that are likely to do better in the future.

What Funds Use Smart Beta?

Smart Beta funds are a method for investing that is being adopted by many asset managers. It is a relatively new development in an investment strategy known as “factor investing.” Factor investing has been used by institutional and fund managers for a long therafter.

The name indicates that the focus is not on the company of individual stocks or bonds, but the underlying factors in the market. Some of these factors include performance, volatility, and value.

Smart Beta funds focus on the traditional six factors, such as momentum, but also include factors such as quality. Quality investing is based on the idea that you may get a higher return because quality stocks tend to take a longer time to go out of business.

Smart Beta funds are considered a type of Exchange-traded fund (ETF) because of their true portfolio of stocks and bonds. ETFs allow investors to invest in a number of companies in one bundle that makes buying one or two stocks easy.

As traditional index funds continue to show only modest returns with declines as well, smart beta funds are beginning to take off.

The Risks of Smart Beta

So, what does investing in smart beta actually mean? As an active fund manager, you decide what factors you’d like to emphasize by sifting through thousands of stocks, looking for securities that have potential. Then you allocate your portfolio based on the strategies you’ve determined.

Smart beta, on the other hand, involves automatic selection that’s based on predetermined criteria. For instance, instead of focusing on a company’s profitability or return on equity, a smart beta strategy might rely on other factors such as valuation or volatility. More importantly, these factors would be weighted based on each investor’s preferences or beliefs.

The downside is that smart beta is heavily determined by the criteria you choose. If these criteria don’t pan out well, smart beta can be a losing proposition. As an investor, you’re putting more trust in the process than with a human, and that’s a large leap of faith.

Then there’s the risk of automated process becoming rigid and inflexible. In some cases, the selection criteria won’t take into account changes taking place within the market. Seeking to maximize a specific factor might lead to subpar results.

Should You Invest in Smart Beta Funds?

Smart beta is basically a smart way to diversify your investment strategy. It comes from the idea that to beat the vast majority of markets, you need to put your money into a combination of a few specific funds, rather than just one standard fund. This combination of funds usually (but not always) includes an active one, a passive one and a factor fund. That means you’re investing using a very specific approach – which isn’t always good. You can find out more about the factors in funds by reading our article about smart beta here.

So it’s quite a mixed bag and it’s not always a good idea to just dive in with both feet. It is okay to have some smart beta in your portfolio. However, you should always look at the bigger picture before adding this type of management strategy to your portfolio. You can find out more about the pros and cons of smart beta here.