Interest in “smart beta”, or “strategic beta,” has grown rapidly in popularity over the past decade. This interest has led fund companies to introduce hundreds of smart beta funds, giving investors a wide range of options for integrating the smart beta concept into their portfolios. As with any investment, though, investors should have an understanding of what smart beta is and how it works before determining if smart beta can help them achieve their investments goals.
Smart beta is based on the more comprehensive factor investment strategy, which has its roots in the discovery of various attributes, or factors, of stocks that help explain their returns. The first factor identified was the well known CAPM Beta. Developed by Willian Sharpe in the 1960s, CAPM is an equation that calculates the expected return of an equity based on a measure of risk called Beta.
Re = βe x ( Rm – Rf ) + Rf
Re is the expected return of the stock in question
Β is the Beta of the stock in question
Rm is the return of the market
Rf is the risk free rate of return
In CAPM, the higher the Beta, the greater the return of the security. And since Beta is a measure of the risk of a security compared to the risk of the market as a whole, CAPM can be distilled to “higher risk, higher return.” The first factor, then, is risk as measured by Beta.
A number of other factors have since been identified. In the 1990s, Eugene Fama and Kenneth French developed the Fama-French Three Factor Model. This model identified value and size as new factors along with Sharpe’s Beta and was the result of research which showed that small companies (size factor) and companies with lower valuations compared to those of their peers (value) tended to outperform over time. Other asset pricing models using these and newer factors, such as the momentum and quality factors, have been developed since then.
There are now hundreds of funds that target these factors. Most will target one individual factor, but other may take a multi-factor approach. They all allow investors to target specific segments of the market which have outperformed historically without investing in expensive, actively managed funds. This is not to say that investors should just blindly invest in smart beta funds. Investors should do their research to understand the risks involved and should be mindful of their investment goals before adding these funds to their portfolios.
With the rapid growth of the smart beta segment, it is easy to find differences in factor definitions between funds. For instance, some funds may have a higher valuation threshold for size than others, so two size targeted funds may have different makeups, even if the stock universe that they pull from is the same. Sometimes terms can be different between funds, with momentum occasionally called “trend,” and “quality” and “profitability” being interchangeable in some cases, but not in others. In addition, newer, less well-known factors may have much less research behind, them and some of the more established factors may have actually underperformed in recent periods. Understanding exactly what you are investing in is as important as ever with smart beta funds. Take the time to know both the factor and its history and how the fund uses that factor before making an investment.
Smart beta funds are generally considered passively managed funds, but while index-based fund holdings are according to market weight, smart beta funds are a bit more complex. Weighting is done to target factors, and some funds will use screens to filter out more than just their factors screens would allow. Each fund develops its own set of rules to determine how to best target a certain factor. Comparing smart beta funds to a benchmark can be difficult as well, as they tend to pull from all areas of the market when targeting a specific factor. Performance will likely vary widely from common market benchmarks such as the S&P 500.
Diversification can also be an issue when investing in smart beta funds. Despite data showing long term outperformance, individual factors can go though years long periods of underperformance. Targeting just one factor in a portfolio can decrease diversification, increasing risk unnecessarily and adversely affect returns if that factor’s performance falters. In addition, targeting some factors can leave you overexposed to certain market segments. The low volatility factor, for instance, can overweight the utility sector. If you’re already invested in that sector through other strategies, targeting the low volatility factor can increase risk in your portfolio.
As with asset class strategies, returns from smart beta tends to be driven by returns from a few well performing companies. Its important to ensure that your smart beta investments are well diversified within an asset class as well as across asset classes to avoid missing out on returns from that handful of companies.
Don’t forget to pay attention to the cost of your investment. Because smart beta focuses on easily definable metrics, smart beta funds are generally fairly inexpensive, but they are not as cheap as index funds. Furthermore, turnover in a smart beta fund may be higher, especially with a shorter-term factor such as momentum. Higher expenses can quickly eat up any outsized returns a fund generates, so it is critical to be aware of how much these funds cost to invest in.
Finally, don’t lose sight of your investment goals. When a hot new strategy comes along, its easy to be tempted to go all in chasing returns and expose your portfolio to unnecessary risk and expense. Take the time to evaluate the smart beta strategy and understand how integrating it into your portfolio will align with your financial plan and help you achieve your investment objectives.
Posts from the same category:
- CBD merchant account
- If you want to make a profit in trading then follow the best forex signals provider
- Monezilax System
- Terry Ritchie on Unraveling Cross-Border Financial Planning
- How to open a bank account for company registration in Slovenia?
- Necessity of Financial Independence in your Life
- Best Forex Robot in 2013