What is Smart Beta?

Smart beta investing combines the benefits of passive investing with the advantages of active investing strategies. At a cost higher than pure index investment but less than conventional active management, smart beta aims to achieve alpha, reduce risk, or boost diversity. It looks for the best way to put together an appropriately diversified portfolio. Smart beta is a hybrid of value investing and efficient market theory. The intelligent beta investing strategy applies to multi-asset classes, fixed income, stocks, and commodities. Through his work on current portfolio theory, economist Harry Markowitz first proposed the hypothesis of intelligent beta.

Smart Beta Explained

A group of investing techniques known as “smart beta” focuses on using index formation procedures other than the conventional market capitalization-based ones. Smart beta focuses on transparency and rule-based capture of market inefficiencies or investing variables. Smart beta is becoming increasingly popular because investors want to control the risk in their portfolios, diversify across different factors, and raise risk-adjusted returns above cap-weighted indexes.

In addition to considering various weighting schemes, including volatility, liquidity, quality, value, size, and momentum, intelligent beta strategies aim to track indexes passively. This is because clever beta methods are used similarly to conventional index strategies, except the index criteria are clear and defined. These funds concentrate on segments of the market that provide the potential for exploitation rather than following traditional indexes like the S&P 500 or the Nasdaq 100 Index.

Choosing Wise Beta Techniques

Although some managers are prescriptive in discovering imaginative beta concepts that are value-creating and economically intuitive, there is no one right way to design a beta investment strategy since investors’ demands might vary. Equity Smart Beta aims to rectify the inefficiencies resulting from benchmarks weighted by market capitalization. To reduce this risk, funds may focus on a particular theme, such as investor mispricing due to their desire for quick gains.

Additionally, managers can design or use an index that weights assets based on characteristics other than market capitalization, including book value or profits.

As an alternative, managers might use a risk-weighted strategy for smart beta, which entails creating an index based on forecasts of future volatility. This includes examining past performance and the relationship between the risk and return of an investment. The management may approach the index by assuming various correlations, but they must assess how many assumptions they are prepared to construct into the index.

The popularity of Smart Beta

Despite charging more significant fees than their vanilla equivalents, bright beta funds are nevertheless well-liked by investors. According to FactSet statistics cited by ETF.com, as of February 2019, 77 new beta exchange-traded funds (ETFs) have debuted, making up around one-third of all ETFs that had entered the market the previous year. Over time, assets under management (AUM) for intelligent beta funds increased faster than vanilla funds, expanding at 10.9% vs. 4.3%. The total cumulative assets that astute beta funds command now stand at $880 billion, up from $616 billion in 2016.

An illustration of an innovative beta fund

The three ETFs listed below, which aim for value, growth, and dividend appreciation, respectively, each use a distinct smart beta strategy:

The Vanguard Value Index Fund ETF Shares ETF (VTV) is responsible for tracking the CRSP US Large Cap Value Index. Its benchmark determines value using several fundamental factors, such as price-to-book (P/B), price-to-earnings (future P/E), historical P/E, dividend-to-price, and price-to-sales. As of April 2019, the fund had $77.25 billion in AUM.

The goal of the iShares Russell 1000 Growth ETF (IWF), which has net assets of $42.73 billion as of April 2019, is to provide returns that are comparable to those of the Russell 1000® Growth Index. The underlying uses There are three primary criteria for choosing components: price-to-book, medium-term growth estimates, and sales per share growth.

Comparable investment returns are the goal of the Vanguard Dividend Appreciation Index Fund ETF Shares (VIG) and the Nasdaq US Dividend Achievers Select Index. The fund weights its assets based on market capitalization and chooses companies that have raised dividend payments over the last ten years. VIG has an AUM of $40.94 billion as of April 2019.

Conclusion

• Smart beta investing merges the advantages of active and passive investment methods.
• As an alternative to conventional market capitalization-based indexes, smart beta employs different index creation rules.
• Smart beta focuses on transparency and rule-based capture of market inefficiencies or investing variables.
• Astute beta strategies may use various weighting systems, including volatility, liquidity, quality, value, size, and momentum.
• As of 2019, smart-beta funds had under management $880 billion in total assets.