What is smart beta and how does it affect your investments?

First things first: defining “alpha” and “beta”

Let’s start the discussion of smart beta with the definitions of alpha and beta. Here they are, according to Investopedia:

Alpha: 1. A measure of performance on a risk-adjusted basis. 2. The abnormal rate of return on a security or portfolio in excess of what would be predicted by an equilibrium model like the capital asset pricing model (CAPM).

Let's put that in plain English. Alpha is the amount of difference between the performance of a portfolio and that of the market.

For example, if the performance of the fund is perfectly correlated with the underlying index that it tracks, its alpha is 0. If the fund does 5% better than the index, then the fund’s alpha is 5. If the fund does 5% worse than the index, then its alpha is –5.

And…

Beta is a measure of the volatility, or systemic risk, of a security or a portfolio in comparison to the market as a whole. Beta is used in the capital asset pricing model (CAPM), which calculates the expected return of an asset based on its beta and expected market returns. Beta is also known as the beta coefficient.

Again, in plain English: Beta shows volatility. It represents how a given stock or fund reacts to market swings. A beta of 1 means that a stock or a fund generally moves in sync with the market. A beta of less than 1 means that the security is less volatile than the underlying market. A beta greater than 1 means that the security or fund is more volatile than the market.

If a beta is reported as 1.2, it means that the stock or fund is 20% more volatile than the market. A beta of 0.75% means that it’s 25% less volatile than the market.

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What is smart beta?

Smart beta investing tries to lower risk and improve returns and diversification. It’s a passive investment strategy based on stock indexes but one that also recognizes other things, such as volatility, that can influence stock prices.

The cost of smart beta investing is slightly higher than traditional index investing but less than traditional active investing.

The method used for smart beta can vary somewhat, depending on the goals of the fund or of specific investors. For example, a manager might want to avoid the way indexes give more weight to larger companies. Or a fund may follow an index that weighs investments according to fundamentals, such as dividend payouts, revenue growth, book value or earnings. Or a manager may follow historical performance between risk and return of stocks.

There’s a lot more to this than we have time or space to cover, and your eyes will probably glaze over if we go much deeper. So let’s move on to the more practical aspects of smart beta.

How smart beta affects investors

As mentioned above, smart beta deals with funds — particularly index funds. It's also common with robo advisors, which make liberal use of MPT. Funds and individual securities commonly report both the alpha and beta. This tends to be more relevant to some investors than to others.

Betas usually fall somewhere between 0 and 2 for both individual securities and funds. Meanwhile, a common market index, such as the S&P 500 index, represents the overall market and has a beta of 1. A beta of 0 means that a stock or a fund is 100% less volatile than the S&P 500 (think U.S. Treasury bills). A beta of 2 means that it’s twice as volatile. That might be a penny stock.

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Does smart beta outperform the market?

As to whether or not smart beta outperforms the market, that’s the dream. But is it the reality?

A September 2016 study conducted by Invesco gives hope. The study showed that over 25 years (1991–2015), smart beta investing strategies outperformed the S&P 500 by between 0.80% and 2.50%, depending on the weighting method examined. That’s impressive, especially when you consider the fact that beating the market over a long period of time is generally thought to be impossible.

Which robo advisors use smart beta?

A small number of robo advisors have added smart beta to their functionality.

For instance, Empower offers the smart beta function, as does Wealthfront. Be advised that while Wealthfront offers a set annual fee of 0.25% per year, Empower uses a tiered approach.

With Empower, the wealth management fees break down as follows: for the first $1 million, the fee is 0.89%; for $1-3 million, it's 0.79%; $3-5 million it's 0.69%; $5-10 million it's 0.59%; over $10 million it's 0.49%.

What funds use smart beta?

There are now hundreds of mutual funds and ETFs that use smart beta investing. Once again, it’s a common strategy used by robo advisors. This means that investors have many opportunities to invest using smart beta. Smart beta ETFs may be the best way to directly capitalize on the smart beta advantage.

There are various fund families that offer multiple smart beta ETF choices, based on different criteria. Those fund families include iShares, Oppenheimer Funds, Vanguard, and Guggenheim.

The risks of smart beta

Not everyone is convinced that smart beta is the investing magic bullet. No less an authority than Vanguard’s founder, Jack Bogle, recently warned that smart beta funds may be over-promising. He maintains that smart beta funds are so new that they have yet to be tested by a market shock.

In fact, smart beta funds have been around since the early 2000s. But the problem is that most have come into existence only after the Financial Meltdown. That means that they have never weathered a major downturn in the market.

Smart beta funds are actively managed. So they have higher fees than purely passive funds. Those small differences in fees can have a big impact over the long term. And they will also exaggerate losses in a declining market.

Another problem is changing market conditions. Like pretty much everything else in the investment universe, smart beta is based on past performance. Should things change in the future, the performance of smart beta funds could decline relative to the general market.

And finally, there’s the popularity factor. Smart beta funds are a relatively small slice of the current fund pie. So they tend to have more breathing room. But as the strategy becomes more popular with investors, more funds will enter the space. This competition could make it more difficult for individual funds to maneuver.

Should you invest in smart beta funds?

The data presented by the Invesco study certainly supports the strategy as a winner. But it also includes data going back to 1991, long before there were any smart beta funds.

There are also warnings that should not be ignored by market veterans like Jack Bogle. He maintains that no actively managed investment strategy can beat the market over the long term. Various studies have proven this assertion to be true. If nothing else, the Law of Changing Circumstances practically guarantees that whatever’s working well now will fail to do so at some point in the future.

If you currently have money sitting in robo advisor accounts, you’re already participating in smart beta investing. But whether you should load up in the strategy by also investing in smart beta funds is an open question.