“Smart beta” is an investment term that became popular over the last decade as investors sought assets that could provide strong returns without taking outsized risk. 

It’s a strategy that combines a passive investing approach with an active strategy. How can that be? Well, a smart beta fund often has a relatively low annual expense ratio but features some kind of rules-based security selection method. 

Smart beta and what’s known as “factor investing” often go hand in hand – they both aim to give individual investors access to alternative index styles that were once reserved for only the institutional class.

Allio believes everyone should have equal access to the best investment strategies. Today’s technology and low costs make it easier than ever to craft personalized portfolios, but there are dangers. Let’s dig in to see if smart beta funds are right for you.

What is Smart Beta?

Smart Beta is a hybrid investment approach that combines active and passive strategies. The goal is to offer individuals low-cost solutions that can beat a traditional market-cap-weighted stock index fund with lower volatility. It sounds too good to be true, right? 

That’s what many seasoned practitioners would say, and the actual performances of a variety of smart beta exchange-traded funds (ETFs) are mixed. Some skeptics even dub smart beta as a fancy Wall Street marketing gimmick used to lure unsuspecting investors into slightly higher-cost products.

Smart beta is often used alongside the term “factor investing.” Factor investing simply isolates one part of the stock or bond market and focuses on that. For example, popular equity factors include value, size, volatility, momentum, and quality. Academic research proves that during certain timeframes, any of those can indeed provide strong risk-adjusted returns. Smart beta portfolios might house several of these factors in what are known as “multi-factor” funds.

How Smart Beta Works

Smart beta funds should not be seen as a villain to the everyday investor. While they carry a slightly higher cost versus a plain vanilla market-cap weighted index fund, most are inexpensive and feature low turnover to keep taxes low. 

The term itself describes what the goal is. Finance students and professionals might be familiar with “beta,” which measures how volatile a stock or fund is compared to the S&P 500. “Smart” beta simply looks to earn outsized returns while keeping “beta” in check.

Smart Beta Strategies

Smart beta strategies work by slightly adjusting the exposure an investor would get with a traditional ETF or mutual fund that tracks a common index like the Dow Jones Industrial Average, S&P 500, Nasdaq 100, or Russell 2000. While the Dow uses a price-weighted scheme, where higher-priced shares command a greater weight, the others simply match the index position to its market cap size – the bigger the stock by size, the bigger its index weighting.

Smart beta plays will often use an equal-weight tactic where each stock, regardless of its market cap, has the same position in size in the portfolio. For instance, an equal-weight fund with 100 stocks would periodically rebalance so that each position has a 1% weight. Some researchers found that equal-weight portfolios perform better than their cap-weighted peers.

Other smart beta ETFs use a more complex fundamentally-weighted approach that seeks to hold more shares of a company that demonstrates, say, a track record of high profits or free cash flow. Another common fundamental smart beta theme is to own a certain group of high-dividend stocks. The “low volatility” factor became quite popular in the 2010s as a vehicle for owning stocks that had both strong performances in uptrends but also did not drop severely during bear markets.

Smart beta is not confined to the stock market space. Bond investors have their so-called “factor zoo” from which to choose. A simple online search will reveal hundreds of equity smart beta funds seeking to pounce on a specific theme and an overwhelming number of fixed-income funds doing the same. Investors sometimes fall victim to the ‘paradox of choice’ bias with so many investment choices today.

Pros of Smart Beta

Smart beta has helped bring quantitative investment solutions from the institutional level to the retail level. It’s now easy to access an equal-weight strategy at a very low cost. For example, a popular S&P 500 equal-weight fund carries an annual expense ratio of just 0.20% (or $20 per year on a $10,000 investment). There are also suites of low-cost factor funds from major fund companies that feature expense ratios of 0.15% or less.

Both active investors and strictly passive-fund proponents should appreciate smart beta and factor funds. Even many of the “Bogleheads” adhere to a long-term portfolio approach putting tilts on the value and size qualities. Meanwhile, active investors and traders occasionally use smart beta themes to jump on board a trend in the market, like value outperforming growth equities.

Are you a values-based investor? Are there certain beliefs you hold that you want to be exhibited by way of the companies you own? If so, smart beta can be a big win for you. By comparing a set of factor funds, you can find one that not only capitalizes on an evidenced-based market trend but also one that is aligned with how you want to impact the world. Smart beta has made investing in certain environmental, social, and governance (ESG) issues low-cost and efficient.

Finally, today’s smart beta ETFs can help you weather current economic storms like inflation and macroeconomic headwinds. There are new ETFs designed to benefit from sharply rising consumer prices and even ones that increase in value when volatility rises. Owning those funds at the right time creates opportunistic alpha, or outperformance, versus a cookie-cutter index fund.

Dangers of Smart Beta

It’s so easy for even savvy investors to be enthralled by a particular smart beta strategy. ETF companies are crafty with how they name their funds and their marketing methods. For example, a researcher at a fund company might discover that small-cap stocks based in Japan in the Financials sector that pay high dividends have historically provided strong risk-adjusted returns. So, they make an ETF for that and perform a backtesting study to demonstrate how well a hypothetical investment in that smart beta strategy would have done. In reality, it might have just been by chance that the small group of stocks performed so well. 

Of course, not every fund company has a nefarious motive. Some factor ETFs are absolutely solid products for retail investors. We just urge folks to have a degree of skepticism when entering the factor zoo. Overconfident investors can easily complicate their portfolios by getting too cute and picking dozens of unique factors in an attempt to beat the market. When you’re starting out investing, often simplicity wins out. Moreover, when you own more than a few of the major factors, you effectively are owning the entire market anyway.

Tried and true index fund investors scoff at the variety of smart beta ETFs these days. They’ll point to evidence that shows that over the long run, the performance of smart beta strategies and factor ETFs tend to revert to the market’s return. 

One last risk: survivorship bias. Survivorship bias is the reality that poor-performing funds close up shop while those that happen to beat the market tend to last longer. The result is that only the top funds are left, and unsuspecting investors are led to believe that their alpha will persist. You might buy a smart beta fund with a strong recent history of annual returns only to see it turn south. Some of these ETFs eventually dissolve due to either weak performance, or, more commonly, simply from investors leaving for other new strategies.

Being a Better Investor

Maybe after weighing the pros and cons of smart beta, you want to have some exposure to this fascinating area of the investing world. We have some tips that can help you achieve solid returns without getting bogged down. 

1. Understand the fund’s strategy. 

You don’t have to read every page of a mutual fund or ETF’s prospectus, but you will want to review a fund’s website and its fact sheet to figure out if it aligns with your values and goals. The last thing you want is to invest your money in something you thought was one thing but turns out to be something totally different and opposed to your philosophy.

2. Compare the costs to that of a basic index fund.

While some of the biggest smart beta funds have minimal annual expense ratios, others are quite pricey – to the tune of 1% or more per year in fees. You also want to know how frequently its portfolio managers trade since constantly getting in and out of securities can drive up your tax bill. Of course, you can bypass turnover risk and tax impacts by owning smart beta products in a personal retirement account like a Roth IRA or 401(k) and even your Health Savings Account (HSA).

3. What’s your goal? How can this smart beta fund get you there?

Are you simply investing for the long haul and not looking to pounce on near-term moves in the stock market? If so, then you must carefully choose among the smart beta strategies that are out there. A basic value fund or momentum ETF could be ideal while a hyper-niche ETF probably is not right for you. 

4. What are the risks? 

We mentioned several risks including turnover risk and funds with fees that are too high, among others. You want to be sure you know details of an ETF’s portfolio, such as how much is weighted to a certain country or region, how big the fund is, how strong its daily liquidity is, and even getting unbiased viewpoints from independent fund research companies can help. 

The Bottom Line

Allio believes investors big and small should have access to the best investment solutions to help them reach their goals. A strategy customized to your values, risk profile, and time horizon should not be reserved for the ultra-wealthy. Smart beta strategies can help you create a portfolio you can stick to without it costing an arm and a leg. Recognizing smart beta investing risks is imperative, though.