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Investors enjoying a steady diet of smart beta

Smart beta has been one of the fastest-growing investment strategies in the United States, with investors adding roughly $10 billion to smart beta mutual and exchange-traded funds in the last 12 months.

It is one of the few equity segments to see inflows so far in 2016, as money has rushed out the door to bonds, gold and Treasurys.

Graphs, beta, information
Michael Blann | Getty Images

But even as investors enthusiastically embrace these strategies, many people still have questions: How is smart beta defined? What role does it play in a portfolio? And why is it gaining traction now?

The answers to these questions start with looking at the broad, persistent forces that tend to drive returns in your portfolio.

First, smart beta emphasizes capturing investment factors or market inefficiencies in a rules-based and transparent way.

So what are factors? They are the building blocks of portfolios.

I compare smart beta to the nutrients in foods. Just as fat and proteins are present in both cheese and meat, you'll find that certain common factors, such as value or momentum, are pervasively present in stocks and bonds.

Distilling factors

Dozens of asset classes and millions of securities can be distilled into a small number of factors. Some of the better-known style factors include:

  • Quality: Stocks of financially healthier companies with consistent earnings growth and low debt.
  • Value: Securities that are priced at a discount to their fundamentals.
  • Momentum: Following upward trends in systematic way.
  • Size: Purchasing smaller-capitalization stocks.
  • Minimum volatility: Lower-risk stocks.

There are also macroeconomic factors, such as the rate of inflation or the pace of economic growth, which have a broader sweep and drive returns across stocks, bonds, commodities and other asset classes.

Knowing about factors is important because, just as the foods you eat can help you to maintain a balanced diet, factors may be able to help you build a "healthier" mix of investments to seek the outcomes that you ultimately want — whether it's outperforming the market, minimizing risk, generating income or improving diversification.

Smart beta ETFs are vehicles that give investors convenient, low-cost access to certain factors. Like other index funds, smart beta ETFs generally track an index; however, rather than tracking a market-cap weighted index, these baskets of stocks or bonds are screened for securities that meet rules-based criteria for one or more factors.

For example, minimum-volatility ETFs track an index that systematically screens for lower-risk stocks. In capturing this well-known factor, minimum-volatility strategies have historically performed well in volatile and distressed equity markets and have provided a way to help reduce risk while still staying invested.

"Smart beta strategies are remarkably versatile tools. They make it easy for investors to target time-tested phenomena — factors — and use them to build portfolios in ways that were simply not possible in the past."

The ability to dig deeper than the broader markets and directly access the underlying drivers of return can make smart beta strategies valuable for building portfolios that target your objectives.

Where did factors come from? Factors aren't a new phenomenon. Value investing has been around seemingly forever, and the potential return advantages of small-cap or lower-volatility stocks have long been recognized. Active managers have been applying factor insights since at least the 1930s in their efforts to beat the market and manage risk.

So why all the attention on smart beta and factors now? In a word, technology.

About 30 years ago, fund managers had to spend significant time and money to gain an edge over the markets. As with so many other areas of our lives, access to computing power and the sheer breadth of data now available have transformed the investment industry. Technology has shifted the balance of power. It has democratized access to information that was once reserved for the most sophisticated institutions and, through smart beta, has put it within reach of all investors.

Smart beta strategies are remarkably versatile tools. They make it easy for investors to target time-tested phenomena — factors — and use them to build portfolios in ways that were simply not possible in the past. Think of it as a new revolution, decades in the making.

— By Sara Shores, global head of smart beta, head of investment strategy for the factor-based strategy group at BlackRock