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Advantages and Disadvantages of Smart Beta Investing

Conventional wisdom suggests that passively managed funds will outperform actively managed funds over a long investment horizon. Passive management is most commonly associated with index funds, which can be mutual funds or exchange traded funds (ETFs) that track the performance of a benchmark index. Some of the oldest and best known indices that these funds track include the Dow Jones Industrial Average (DJIA) which uses weighted prices; suggesting that a higher stock price has a greater value in determining the value of the index.

Most other widely known indices, including the S&P 500 (^GSPC) or Nasdaq 100 (NDX) use a company’s market capitalization in determining how much weight that particular stock will have in the index. A company like Apple (AAPL), which has a market cap of $607.6 billion, is estimated to make up about 3.57% of the S&P 500. Recently a marketing tactic has penetrated the world of finance, smart beta describes funds that factor in anything other than market cap in weighing their holdings. Smart beta funds are constructed on underlying measures such as volatility or earnings and have been described as a modest mix of active and passive investing.

The Basics of Smart Beta

In finance, beta has become a universal measure of the systemic risk of a portfolio in comparison to the market as a whole. This volatility measure gives you a sense of how far the fund varies from the market. A beta greater than 1 reflects an asset with more volatility than the market and less than 1 equals less volatility. By proxy, smart beta refers to passively managed funds, which are designed to systematically take advantage of market inefficiencies in order to improve returns.

The emergence of smart beta assets came as a result of several shifting trends in the investment management industry. Over the past several years, investors have increasingly embraced index investing as a vehicle with inherent transparency, consistency, low fees and passive management.

However, following significant losses by large cap and growth stocks in the dot com crash, investor’s interest for non-market cap index strategies increased. With the advances in technology, many of the insights that were historically available to investment analysts could now be captured in a more systematic fashion. This intersection of trends has largely driven the creation and adoption of smart beta strategies.

Fundamentally, smart beta seeks to improve returns, reduce risk and increase diversification while delivering greater exposure to the market. By combining both characteristics of passive and active investing, investors retain many benefits of passive strategies while also attempting to improve returns. Smart beta strategies implement a rule based alternative to passive investing outside of the traditional weighted cap strategy. Besides greater exposure and diversification, funds attempt to increase risk adjusted returns by taking advantage of known anomalies in asset classes.

Currently, Nasdaq is one of the largest smart beta providers in index linked exchange traded funds. Some of their most popular brands, AlphaDEX, Dividend Achievers and Multi-Asset indexes are all designed to provide exposure outside of a traditional index fund. For example, the Nasdaq Dividend Achievers are funds composed of companies with a history of increasing dividend yields. These companies are selected under the premise of enhancing shareholder value through dividend payouts. In particular, the U.S. Dividend Achievers Select Index (DVG) comprises of companies with ten or more consecutive years of increasing dividend payments.

Advantages

Fundamentally, investors choose smart beta funds for potential returns above the market average. By isolating investment decisions, investors can more precisely and efficiently capture various anomalies. This allows investors to better align their portfolio with their preferences whether it is a cost reducing strategy or risk aversion. A smart beta strategy can complement traditional index funds and offer an efficient means of leveraging exposure throughout the investment process, from portfolio design to construction. Many of these funds maintain the benefits of traditional index funds, including transparency, diversification, liquidity and low transaction fees.

Disadvantages

Compared to traditional index funds, smart beta strategies are inherently more costly, risky, and exhibit extended periods of underperformance. While investing in traditional index funds has minimal costs, smart beta funds carry higher expense ratios, portfolio turnover and rebalancing costs. In addition to higher costs, investors who buy into Smart Beta are simply putting more risk into their portfolios for the opportunity for higher returns. The concept of high risk, high reward has been fundamental to finance throughout history and remains no different here.

To this point, the category of smart beta still remains in its infancy. Besides its established status in equities, smart beta will likely evolve to include more fixed income, multi-asset classes and outcome oriented goals. By also incorporating long and short positions, smart beta assets can better encompass the power of factor based investing. As the financial market continues to evolve, asset classes like smart beta, which seek to address market inefficiencies, will emerge and gain popularity.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.


The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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Trevir Nath

Trevir Nath graduated in 2011 from Rutgers University with a Bachelors in Economics & Psychology. His Psychology and Economics degrees increased his understanding of financial markets from a human behavior perspective. Looking to further his understanding of financial markets, he went on to obtain his Masters in Economics from the New School graduating in May 2014. He currently writes about personal finance, investing and its interaction with technology. His work also appears for numerous financial websites including Investopedia.

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