Smart beta investing: understanding the basics

Smart beta is a rules-based investing strategy that combines some of the principles of active management with a passive approach, typically through an exchange-traded fund (ETF) or mutual fund. Because there are so many different approaches to smart beta, it’s worth breaking smart beta down into its core elements to see what really sets it apart from other investment approaches.

Smart beta investing: understanding the basics

The ABCs of smart beta

Named after the second letter of the Greek alphabet, beta is a measure of risk or historical volatility that compares an investment’s risk to that of the broader market. A beta of 1.0, for example, means that an investment’s risk is equal to the market’s risk. Put another way, the investment has shown a tendency to behave according to how the market moves—the lower or higher the beta, the lower or higher the volatility of the investment relative to the market. A beta of 0.9 means an investment is 10% less volatile than the market, for example. Passive investments such as market-cap-weighted ETFs and index mutual funds seek to track the beta of a particular market—the S&P 500 Index, for example—and thereby achieve market-like returns.

On the other hand, actively managed investments, including most mutual funds and some active ETFs, seek to create alpha, which is the measure of return that’s over and above a market or benchmark. In traditional actively managed strategies, portfolio managers pick stocks and weight sectors so that their portfolio deliberately differs from the benchmark. This involves overweighting investments that seem to be more attractive opportunities and reducing or eliminating exposure to less attractive opportunities—all with a goal of outperforming the benchmark over time. 

The goals of smart beta

Smart beta is like active management on autopilot. Like active management, most smart beta funds are benchmarked to commercial indexes. Yet unlike active management, security selection isn’t managed on a daily basis by a team of professional investors, but rather it’s the product of a predetermined set of rules. This rules-based approach to alpha generation is what distinguishes smart beta from other strategies.

What separates one strategy from the next is the particulars of the rules that each strategy adheres to. Sometimes the approach will involve redefining a target market—for example, investing in the S&P 500 Index using an equal-weighted approach rather than a market-cap-weighted approach, or to exclude all of the lowest-profitability stocks in the index. The common theme among smart beta approaches is that, like actively managed strategies, they all generally begin with a universe of securities and then redefine how heavily to invest in each holding—or whether to include a holding at all. Instead of relying on a management team’s skill or the quality of their research, smart beta funds follow strict sets of rules designed to provide an unemotional, quantitative process for pursuing a given investment goal.

Smart beta ETFs vs. passive, index-oriented strategies

Why invest using smart beta?

Smart beta investing is growing in popularity as an investment option as investors look for more advanced and effective ways of implementing and balancing active and passive strategies. Larger institutional investors, for example, have been increasingly adopting smart beta approaches. In May 2018, 48% of institutional North American asset owners surveyed by FTSE Russell said they’ve adopted a smart beta approach, up from 37% in 2016. And nearly all managers surveyed have been looking closer at smart beta strategies.

There are a number of reasons that you may want to consider adding smart beta ETFs to your portfolio:

  1. Broad choice. Investors have a wide variety of investments to choose from. Case in point, Morningstar tracks nearly 20 different kinds of strategic beta categories—the term the company uses to refer to smart beta investments—with more than 750 funds available today across those categories.
  2. Cost. When packaged in an ETF, a smart beta strategy may be a low-cost alternative to purchasing an actively managed mutual fund, while still providing access to more targeted strategies than would be possible through a pure-passive approach.
  3. Diversification. Smart beta approaches can help provide diversification in your portfolio. If your portfolio includes all active or all passive investments, smart beta may offer a complementary approach to the markets, which can further diversify the types of strategies in your portfolio.
  4. Discipline. While there’s no guarantee that any investment strategy will meet its objectives, the consistency behind smart beta investment processes may produce more predictable, explainable results over time.

Want to find out more? Check out our ETF investing page. Your financial advisor can help you determine if smart beta strategies are a good fit for your portfolio, and how these investments might align with your financial goals.