"Smart beta" has become the buzzword du jour in the exchange traded fund market as more investors consider straddling the divide between active and passive portfolio management.
Since 2011, dozens of new products that have come to the domestic ETF market can be characterized as "smart beta," whether they include words such as "volatility," "hedged" or "equal weight" in their name. But what does "smart beta" mean, exactly? And how can advisors determine whether a smart-beta strategy truly reflects a wise investment choice for client portfolios?
Larry Swedroe, director of research with the Buckingham Family of Financial Services and the BAM Alliance and author of The Incredible Shrinking Alpha (BAM Alliance Press, January 2015), believes that much of what is called "smart beta" is merely marketing-speak because fund companies are chasing a shrinking supply of alpha as markets become more efficient.
Beta represents a portfolio's sensitivity to market movements, and it can be used to measure a security's exposure to risk, Swedroe points out. Beyond that, "there's nothing smart about it," he said in a phone interview on Tuesday, asserting that the concept of smart beta comes from active managers who tilt their portfolios away from market risk and toward small and value stocks.
"If you construct a value fund with small stocks that kicks out initial public offerings, bankruptcies and small companies that aren't profitable, the screening of those duds is smart beta," Swedroe said.
Here are three essential ways to determine how smart-beta ETFs might fit in a client portfolio.
1) Fundamentals Trump Market Cap
Smart-beta indexes tilt toward value stocks that perform well over time, according to Tony Davidow, vice president of alternative beta and asset allocation strategist with the Schwab Center for Financial Research.
The "alternative beta" investment method for ETFs weights securities based on fundamental factors such as sales, cash flow and dividends plus buyback, Davidow said in a Tuesday phone interview. He said the typical S&P 500 index fund owns all 500 stocks in the index but doesn't invest an equal amount in each. Traditional index fund weights are determined by market capitalization, so that big players, such as Apple Corp., end up comprising a disproportionate share of the fund, he said.
"We think of strategic-beta ETFs as fitting into a continuum between traditional market cap strategies and active managers who seek to deliver returns," Davidow said. "By definition, they're not active. They're rules-based. The rules are established in advance, and they're disciplined and founded in academic rigor. An index is unemotional and doesn't alter the strategy based on emotions or current market conditions."
Morningstar Inc. has created taxonomy to categorize smart-beta ETFs, which reached a magnitude of $400 billion in third-quarter 2014 in assets under management, Davidow said.
