While definitions of these funds abound, as the name implies, they aim to beat the market (beta), either with better performance or better management of risks. They try to do that by tracking an index weighted according to factors other than market capitalization, such as dividend-paying policies, fundamental strength, value, momentum or low volatility. In other words, they try to do what active managers do, but in a rules-based, transparent and inexpensive way.
Since the financial crisis, the demand for these funds has exploded. Research firm Morningstar was monitoring 708 such funds, with $740 billion in assets, at the end of January. That compares to 213 funds managing $133 billion in 2009. "Investors are using these funds as a replacement for active strategies," said Alex Bryan, director of passive strategies research at Morningstar.
While smart beta is the commonly used label for these funds, Morningstar prefers the term strategic beta.
"Not all these strategies are smart," said Bryan. "Sometimes they work, and sometimes they don't."
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He added, "People need to evaluate them like they do active managers."
Rob Arnott, founder of Research Affiliates and widely credited with pioneering the concept of smart beta investing, thinks the term no longer has meaning.
"It's been stretched to encompass just about everything formulaic, with the result that a lot of dumb ideas are being called smart beta," he said. "It now spans just about everything, so the term effectively means nothing."
Vanguard, the market leader in low-cost index funds, has avoided the term smart beta entirely in its recent product offerings in the space. In mid-February the firm launched six new factor-based ETFs and one new factor-based mutual fund.
The funds target exposure to the factors of value, momentum, quality, low volatility and liquidity. A multifactor fund will combine the factors of momentum, fundamentals strength and value (low price to fundamentals).
"We think we've hit the biggest, most robust factors that investors can use predictively," said John Ameriks, head of Vanguard's Quantitative Equity Group, which will manage the funds. Always skeptical of investment product proliferation, it plans to stick with this lineup. "If there is demand for a broader set of [factor funds], we'll consider it, but we have no plans to enhance this suite," Ameriks said.