What the Heck Is Smart Beta Anyway?

Question: I keep hearing the term "smart beta" in discussions about investing. Can you explain what it is?

Answer: So-called smart beta strategies, also known as factor-based or alternative indexing, were a hot topic at the recent Morningstar ETF Invest Conference in Chicago and have garnered quite a bit of attention lately as a lower-cost way for investors to obtain access to specific investment strategies traditionally available only through actively managed funds.

Most investors already have some familiarity with index-based investing, in which a mutual fund or exchange-traded fund simply replicates all the holdings of a given index. The most widely used indexes, such as the S&P 500, are capitalization-weighted, or cap-weighted, meaning that they, and the funds that track them, allocate holdings based on each company's market capitalization. Thus, bigger companies make up a bigger percentage of the portfolio while smaller companies make up a smaller share.

An Alternative to Cap-Weighting
Critics of cap-weighted index funds point out that they force shareholders to own more shares of stocks that are overpriced while owning fewer shares of those that are underpriced. To avoid this, but also as a way to manage risk in a portfolio, some investors have turned to indexing strategies that ignore market cap in favor of other factors such as share-price volatility, share-price momentum, or company performance. Among the most vocal proponents of factor-based indexing is Rob Arnott, chairman and CEO of Research Affiliates, who, in a speech at the conference, pointed to research showing that a variety of different smart beta strategies--for example, weighting the portfolio based on each constituent's average earnings across five years--all would have outperformed a U.S. cap-weighted portfolio during the past five decades. (You can read more about this research here.)

The word "beta" is sometimes used to refer to the degree to which an investment's performance is attributable to its exposure to risk factors, and thus smart beta refers to the idea of using these factors intelligently to improve performance.

Some basic factor-based approaches are already quite familiar to longtime investors and have been in use for decades. For example, building a value-oriented portfolio based on stocks' price/earnings ratios would be an example of a factor-based approach. In fact, some point to the Morningstar Style Box as a representation of factors in that it classifies investments by size and value, two of the first factors used in factor-based investing. What is new is the sheer variety of approaches being applied to index-based funds and ETFs.

Some examples of smart beta ETFs are as follows:

 PowerShares S&P 500 Low Volatility (SPLV): Tracks the S&P 500 Low Volatility Index, which holds the 100 stocks in the S&P 500 that have had the lowest volatility during the past year. Stocks are weighted by the inverse of their volatility, with steadier stocks making up a bigger share of the index.

IShares MSCI USA Momentum Factor (MTUM): Tracks an index that holds 100-150 large- and mid-cap stocks with the strongest price momentum during the trailing six to 12 months. Holdings are weighted according to their momentum score and market cap.

 WisdomTree LargeCap Dividend (DLN): Tracks an index that holds 300 large dividend-paying companies and weights them according to their projected cash dividends in the coming year.

An Active-Passive Hybrid
In a sense, factor-based indexing mimics strategies that many active fund managers use. But rather than a living human being deciding on which stocks to buy and sell and when based on his analysis, factor-based indexing mechanizes the process by applying a model that determines what goes in the portfolio. This eliminates the need for an active manager and thus helps reduce fees, though factor-based funds and ETFs still tend to charge more than market cap-weighted index funds and ETFs. You might think of factor-based indexing as a hybrid approach that combines the strategic advantages of active management with the lower investment costs offered through indexing.

However, some critics remain unconvinced that smart beta approaches live up to their name, including those who question methods used to back-test their performance. Morningstar's Ben Johnson discusses the debate in this video, while Morningstar's John Rekenthaler explains in this recent column why not all smart beta approaches are likely to be equally reliable.

For investors looking for a way to home in on specific factors when managing their portfolios, or just for a way to replicate an active management strategy in a less expensive, index-based product, smart beta or factor-based funds are certainly worth a look. However, as with any hot investment trend, it's important not to get swept up in the hype. Some of the strategies employed by factor-based funds and ETFs are rather complex, and if you don't have a good understanding of how they work or how the investment is designed to perform, the smart thing for you to do just might be to steer clear.

Have a personal finance question you'd like answered? Send it to TheShortAnswer@morningstar.com.