Smart Beta

Smart beta is an indexing strategy that employs researched factors to choose and determine stocks for an index portfolio. It can give better risk-adjusted returns compared to broad market-cap-weighted indices. These are good investment options for risk-averse investors who expect good profits.

This strategy combines active and passive investing and outperforms the performances of weighted index funds. It allows the investor to reap the benefits of passive strategies while aiming for good returns and minimizing risks. Adopting smart beta techniques can help allocate more thoughtfully to potential investment avenues for risk and return.

Smart beta investing is a strategy that works on stock selection and weighting based on predefined factors. It is an improved indexing method that aims to take advantage of specific performance characteristics to exceed a benchmark index. In this regard, this beta technique is significantly different from a conventional passive indexing approach.

The factors considered are quality, growth, and value. Quality is considered when buying stocks of excellently run companies. It is determined by looking at the return on equity, earnings variability, and debt or equity. The value factor is considered when buying undervalued stocks. It is determined by price or earnings, return on capital employed, and dividend yield. The growth factor is considered when buying stocks of corporations with consistent profit growth. Earnings per share growth frequency determines this.

Quality is considered due to the high efficiency of the stocks, which brings in stable earnings. When the value factor is considered as such, stocks consistently perform well across various market environments. The growth factor is considered when looking at consistent and positive earnings through growth stocks. Based on the criteria, stocks with high prices and book ratios are symbols of good earnings growth potential.

Smart beta methods are different from actively managed mutual funds. The fund manager selects individual stocks or industry sectors to outperform the benchmark index in these mutual funds. Conversely, smart beta strategies aim to increase returns, reduce risk, and improve diversification by investing in tailored indexes or Exchange Traded Funds (ETFs) based on one or more specified factors. They strive to exceed conventional capitalization-weighted benchmarks but often incur fewer costs than conventional, actively managed funds.

Let's look at some examples to understand the concept better:

Example #1

Dan, an investor, decided to test out smart beta strategies in 2021 with his long-term goals in mind. He analyzed the stock market and found that in 2021, SPDR S&P 600 Value (SLYZ) was the top-ranked ETF. The fact that it was top-rated meant that it outweighed conventional funds in terms of growth, technical factors, value, and quality, which were reasons to consider. He also discovered that it was a small ETF with assets under management (AUM) of $182 million and an expense ratio of 0.35%. The ETF displayed neutral momentum factors, low volatility, and an underweight size factor. The ETF had a positive 11.59% YTD (year-to-date). He also had the option of choosing an ETF with an AUM of $3.5 billion and a low expense ratio of 0.7%, but it had only a positive 2.49% return despite having a huge AUM. It showed neutrality in technical, size, and growth factors while being underweight in low volatility, quality value, and momentum factors. Dan went with the former option, as the factors were comparably in a better state for that ETF.

Example #2 

The strategic beta market expanded faster than the overall exchange-traded product (ETP) market for most of the last ten years. New players, launches, and cash flows aided the rise in popularity of strategic beta ETPs. However, the growth in market share for these products has stalled. This market sector has matured and is saturated. Net fresh inflows have leveled off. 2020 saw a decline in the total number of strategic beta ETPs worldwide, for the first time since closures outnumbered new launches. In 2021, only 12 net new products were added to the global strategic beta ETP menu, representing a 0.9% increase from the end of 2020. The market looks saturated, with services no longer in demand. This reduces profitability. Investors need to consider the present market situation before choosing to invest.

Smart alpha, beta, and factor investing are all related to investing; however, they have significant differences, some of which are given below.