One of the newer terms in the investment lexicon is “smart beta.” The concept behind smart beta has been around for quite some time, but now the term appears in the financial press on a regular basis. First of all, beta is a measure of the relative volatility of a security or a portfolio compared to the market. A beta less than one indicates lower volatility, while a beta greater than one indicates higher volatility. While there is no consensus definition of smart beta, in general it is an investment approach that builds an index differently from the traditional market cap weighted indices – in other words, a more specific, “smart” index.
Most indices, like the S&P 500, are constructed based on a stock’s market capitalization. As a result, the largest companies have the greatest impact on the movement of the Index. In addition, since growth companies tend to have higher P/E ratios (which increase market capitalization), market cap weighted indices tend to favor growth companies. Therefore, investors who have a large cap growth bias should appreciate a fund that tracks the S&P 500. However, investors that do not will have some angst with the same fund.
Research has shown that building an index by equally weighting the stocks regularly outperforms the market cap weighted index. Since the index is simply based on a different method of construction and there is no manager actively buying and selling stocks, the equally weighted index is considered a smart beta strategy. There are numerous techniques to create a smart beta portfolio, including weighting stocks based on dividends or valuations, but in essence, these techniques are simply rules-based approaches applied to create passive indices.
Smart beta strategies blend some of the elements of passive indices with some of the benefits of active management. In fact, a recent study has found that active managers who outperform tend to have a factor bias, such as value or size. As a result, active managers have benefitted by capturing the same size and style effects that have benefitted many smart beta strategies.
The term smart beta implies a better way of investing, but unfortunately, it is not a free lunch. As discussed above, equally weighting the stocks of an index regularly outperforms its market cap weighted equivalent, but regularly does not mean always. Equally weighting stocks gives the index a smaller company, value tilt, and historically these factors have provided better returns. However, there have been periods when these factors have lagged. Investors expecting smart beta returns to always excel will be disappointed.
Therefore, while not a panacea for all investment related issues, the blending of passive and active management offers us another tool in helping to meet financial goals. Investors merely need to have realistic expectations.
Washington Trust Bank believes that the information used in this study was obtained from reliable sources, but we do not guarantee its accuracy. Neither the information nor any opinion expressed constitutes a solicitation for business or a recommendation of the purchase or sale of securities or commodities.
Washington Trust Bank.