10 things investors need to know about smart beta

More than 10 years have passed since the launch of the first smart beta exchange-traded fund. As we head into the second decade for smart beta ETFs, it seems like a good time to present 10 things every educated investor should know about this investing approach.

1. First, it's important to understand where the name "smart beta" comes from. Professional services firm Towers Watson coined the term, but institutional investors have used the strategy since the 1970s. Roughly 20 years after the first index mutual fund in 1975, the first ETF debuted in 1993. These were not smart beta funds. The first smart beta ETF launched in 2003.

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2. "Beta" measures the volatility of an individual security/portfolio, as compared to the broader, whole securities market. The stock market, which often uses the S&P 500 index as its proxy, has a beta of one. Individual stocks are then ranked according to how much they deviate from that beta.

A stock with a beta of two has a return that, generally, changes by twice the magnitude of the overall market's returns — whether returns are positive or negative. "Smart" refers to the use of an alternative methodology rather than following an index's size-based (market-cap) allocations.

A smart beta investment strategy is designed to add value by strategically choosing, weighting and rebalancing the companies built into an index based upon objective factors.

3. Smart beta indexes are different from their traditional counterparts. Smart beta applies a series of objective, rules-based screens to each index's component company. Companies are then ranked and weighted based upon these specific factors.

Traditional market-cap weighted indexes, including the S&P 500, weight their constituents based solely on market caps, giving larger companies a bigger slice of the index even if a company is considered overvalued.

Similarly, diminutive companies are given smaller allocations, even if other characteristics indicate they are poised for growth. Smart beta solves this "size" bias through the use of its objective rules-based screens rather than a cap-weighted methodology.

4. Smart beta ETFs are passive investment tools that track smart beta indexes. Smart beta ETFs are designed to track chosen or newly constructed alternatively weighted indexes and its component companies. These indexes overlay analysis of targeted accounting metric factors, such as dividends, cash flow, total sales and book value, which results in a new smart beta index.

Some managers may use other factors, such as low volatility or momentum. Smart beta ETFs, although passive, are still able to leverage active qualities through systematic rebalancing — not done by an active manager, but built into the ETF technology itself.

5. Smart beta ETFs seek to mitigate the challenges of market cap-weighted ETFs. Instead of blindly weighting companies solely according to their size, smart beta uses screens based on fundamental analysis principles to determine which companies should be given a larger piece of the index pie. The goal is increased returns or enhanced risk profile.

6. Smart beta strategies are increasingly popular for investors looking for factor diversification. Investors are increasingly turning to smart beta investments in order to seek outperformance. According to research firm Morningstar, at Sept. 30, 2015, there were more than 450 U.S.-listed smart beta products, with a collective $510 billion in assets.


"Smart beta investments can expand investors' options and should be evaluated based on each investor's investment objectives and time horizon."

7. Not all smart beta strategies are alike. Investors must carefully look under the hood at smart beta ETFs and assess what indexes, biases and specific single- or multifactors each uses, what firm is constituting (and reconstituting) the underlying index and how often, and what firm sponsors the corresponding smart beta ETF.

8. Smart beta ETFs have now been around for more than a decade. Managers of smart beta ETFs have refined and tuned the investment methodologies they employ since the early- to mid-2000s.

Using factors — low volatility, momentum, quality, value and size — to develop an index's underlying holdings, ETF providers are now offering smart beta strategies. These were not available to investors before ETFs and technology made it possible for individual investors to access different factors of the market from home computers and mobile phones.

9. Smart beta strategies may help investors' portfolios outperform benchmark indexes; however, outperformance can't be assured. Data from December 1991 through June 2015, based upon five specific factors, show that U.S. smart beta ETF factors and methodologies outperformed the S&P 500 index over five full market cycles and in different economic climates, although absolute performance varied.

10. One of the most important considerations for investors is to understand how to implement smart beta ETFs. Many investors see investments that feature a smart beta strategy as complementing or tactically enhancing overall performance within a portfolio while providing diversification. Smart beta investments can expand investors' options and should be evaluated based on each investor's investment objectives and time horizon.

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With the Federal Reserve raising rates for the first time in seven years, investors are likely to experience more turbulent global markets and higher volatility impacting their portfolios.

Amid this shifting landscape, smart beta ETFs offer a dynamic toolset for investors to create more diversified, factor-driven portfolios. Factors are the engine that will likely drive smart beta ETFs into the next 10 years.

— By Dan Draper, managing director and head of Invesco PowerShares