One problem with actively managed stock mutual funds is that even when they beat the market, you never quite know why—or if it's likely to happen again. Now some in the fund world believe they have a solution: smart beta investing.
Don't be put off by the name. Wall Street has never been especially good with product branding. Smart beta has the confounding ring of, oh, structured notes or collateralized debt obligations. But in simplest form, smart beta is a nifty index strategy that will make sense for a lot of individuals.
The central idea is to get away from portfolios weighted by market capitalization and which thus have the greatest exposure to the biggest companies. That's generally how popular low-cost index funds operate: Their holdings are a near-perfect match with cap-weighted benchmarks like the S&P 500. So anyone who owns an S&P 500 index fund automatically allocates more money to shares of, say, Exxon Mobil than to Ball Corp.
But what if the Ball Corps. of the world rise faster, as they often do? Smart beta is all about grabbing that outperformance. "We look at conventional indexes and say there is a better way," said Bob Breshock, managing director at Parametric Portfolio Associates, which runs $19 billion of smart beta assets.
Smart beta strategies vary, but they have one thing in common: Size doesn't matter. Some smart beta funds weight the portfolio according to fundamentals like earnings, dividends and cash flow; others weight it to low volatility or upward price momentum. The simplest and oldest smart beta strategy is equal-dollar weighting: investing the same amount of money in every company in an index, large or small.
For a weekend investor it gets tricky. So think of smart beta funds as actively managed portfolios with costs and risks similar to index funds—and with a clear and repeatable strategy that all but eliminates luck as a factor. Sounds pretty great, right?
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