From Passive to Active? Smart Beta Takes Off

In this article, we’ll take a closer look at these growth rates, and whether investors should include smart beta ETFs in their own portfolios.

Smart beta is a transparent and rules-based style of investing that seeks to improve returns, reduce risks and enhance diversification through systematic investment decisions, according to BlackRock. Whereas traditional index investing relies on market capitalizations to weight components, smart beta indexes isolate or combine a number of different factors to determine weights and optimize them for particular outcomes.

Some common smart beta strategies include:

• Minimum Volatility: Min-Vol ETFs attempt to reduce risk in a portfolio by investing only in assets that are less volatile than the overall market. The goal is to deliver more consistent returns and reduce the potential negative impact of a downturn.
• Fundamental Strategies: Fundamental ETFs screen and weight components based on fundamental factors, such as price-earnings ratios or dividend payments. The objective is to select fundamentally sound companies that may be better performers.
• Credit Screened: Credit-screened fixed-income ETFs may look at an issuer’s credit rating, cash flow or other factors when weighting the fund, rather than debt outstanding. The goal is to reduce the risk of default without sacrificing yields.

The key assumption made by smart beta strategies is that the market is inefficient, which runs contrary to the Efficient Market Hypothesis embraced by passive investors. But unlike actively managed funds, smart beta funds are focused on finding mispriced opportunities in a systematic fashion rather than on an individual basis. This tends to help reduce costs and may increase predictability over the long run if a strategy is successful.

Smart beta ETFs have become increasingly popular among investors, but they have also drawn their fair share of criticism among some experts.

WisdomTree, a leading ETF issuer, highlights a number of potential benefits stemming from smart beta ETFs in its literature. Depending on the investor’s goals, these advantages might include enhanced portfolio returns, reduced portfolio risks, increased dividend income or more efficient exposure to the equity risk premium. Achieving these goals is accomplished through smart beta screening for things like volatility or dividend yields.

Critics of smart beta funds argue that “there is no free lunch.” In other words, it may be possible to realize these benefits – but there are also equivalent downsides. A smart beta fund may offer lower volatility and risk, but the natural cost would be less upside potential. There are also other concerns to consider such as higher turnover increasing transaction costs and crowding preventing a strategy from working for a very long time.

Investors may want to incorporate smart beta ETFs into their portfolios for various reasons, although the most obvious reasons may not be the best ones.

There is little data that shows smart beta funds are capable of beating the market in terms of risk-adjusted returns over a long period of time. In fact, the higher turnovers and expense ratios associated with many of these funds make outperforming passively managed index funds increasingly difficult. Some smart beta funds that have outperformed may have also lost their edge as capital has poured into the space.

That said, smart beta ETFs can be extremely useful tools for building customized portfolios to meet certain objectives other than beating the market. For example, a dividend-focused smart beta fund may be able to offer greater and safer dividend payments for an income portfolio, even if the dividends plus capital gains are the same. The trade-off may be worth it to these investors solely seeking greater income from dividends.

Smart beta ETFs are projected to continue growing at a 20% annual clip to reach $1 trillion in assets under management by 2020. While they have attracted a number of skeptics, these funds help to fulfill an important part of a diversified portfolio, and should be considered by investors.