How smart is smart beta?

Money Report

moneyreport“Smart beta” has become A hot topic in the financial world. It has certainly captured the interest of investors, underwriters and brokers.

According to Morningstar, a quarter of all exchange-traded fund investments in the first 11 months of 2013, over $41 billion, went into funds using smart beta strategies.

So what exactly is “smart beta?” It’s a concept used rather broadly to describe alternate investment strategies, which, proponents claim, address the shortcomings of both traditional managed mutual funds, and unmanaged index fund investments. Not all smart beta strategies are alike, so here’s a brief overview.

Investors who believe markets operate pretty much efficiently tend to favor the low cost and broadly diversified index fund approach. Index strategies seek to replicate, with minimal costs, the makeup and performance of a predetermined market benchmark.

For instance, an investor wishing to place funds in large U.S. companies could choose to invest in a fund that seeks to replicate the makeup and return of the Standard & Poor’s 500, or the Dow Jones Industrial Average. Other investors who believe that active management can make a difference, are more willing to pay a fund manager to research, pick and choose among large companies and industries, in order to garner advantage over the broad market. In other words, diversification vs. selectivity.

Both approaches pose some challenges. Most active managers typically underperform indexes over time; this is primarily attributed to higher fees, over- or underweighting market sectors, and market timing. Actively managed funds’ holdings have a lack of transparency compared with index funds, and trading costs and distributed gains also can hurt returns. Index funds, while generally low cost and broadly diversified, can pose problems as well. Most weight their holdings based upon the total value of a company’s outstanding stock, known as market capitalization. This tends to overweight companies whose stocks are highly valued and underweight companies that are out of favor and lower priced, or just with smaller market capitalizations.

Smart Beta, then has become a rather elastic concept that is used to stretch around many different strategies. Three of the most common are equal weighted, fundamental weighted, and quantitative.

Equal weighting is just what it says: stocks are represented equally in the fund, regardless of their market value or capitalization. Fundamental weighting strategies choose stocks based upon some combination of fundamental factors, which could include book value, dividends, earnings or cash flow. A quantitative smart beta approach might assemble its investment universe based upon statistical measures, for instance stocks with lower volatility than the general market.

If this sounds like just another form of active management, smart beta skeptics would agree. However, since these smart beta indices have typically lower fees, more transparency and broader diversification than managed funds, and don’t rely quite so heavily on the focus of a portfolio manager or team, they retain many of the advantages of a more traditional index fund.

One of the leading proponents of smart beta is the noted investment manager and academic Robert Arnott, chairman of Research Affiliates and developer of the

Research Affiliate Fundamental index. His methodology was granted a patent in 2009, and his flagship fund, PowerShares FTSW RAFI US 1000 (PRF), at $2.8 billion, is one of the largest funds using the smart beta approach. PRF uses fundamental factors to construct the index, including dividends, book value and cash flow, and in doing so skates close to the line that separates an index from an actively managed fund.

The Guggenheim Funds Service Group has an exchange traded fund that uses the smart beta equal weighted approach, the Guggenheim S&P 500 Equal Weight fund. Trading under the symbol RSP, this fund returned an average of 9.2% per year over the last 10 years. When considering any smart beta strategies for your portfolio, as with any fund investment, read the prospectus carefully and be sure that risks and potential returns fit in with your overall investment plan.

Steven Weber, Gloria Harris, and Frank Weber are the investment and client services team for The Bedminster Group, providing investment management, estate, and financial planning services. The information contained herein was obtained from sources considered reliable. Their accuracy cannot be guaranteed. The opinions expressed are solely those of the authors and do not necessarily reflect those from any other source. Discussion of individual stocks are informational and do not constitute recommendations to purchase.