Sold as a hybrid solution that adds extra oomph to exchange-traded funds (ETFs) whose competitors simply track indices, so-called “smart beta” funds that invest in sectors with the help of pre-defined screening rules that overlay simple exposure to asset classes or industries have been taking market share rapidly.

According to data from Bloomberg, smart beta has historically beaten the broader market, though with more risk. The risk, however, has not deterred investors from considering, or adding smart beta funds to their portfolios. According to a survey by FTSE Russell, the number of investors who are now evaluating smart beta have doubled in just two years. The biggest growth in terms of investor segment has been with those who have less than $1 billion under management – in 2016, 26% of investors report to own smart beta, compared to only 9% in 2014. Other segments reported more modest growth, but far more investors in those groups already had smart beta in their portfolios.

Smart Beta Strategies

The idea of smart beta is attractive: to soup up returns on funds that track indices by adding a handful of additional screens to the list of securities a particular fund might purchase. Popular strategies include equally weighing assets included in an index rather than using price or capitalization weighting, equally weighting so-called “risk clusters” of similar companies rather than individual stocks, or combining equal weighting and cap weighting. Portfolios can be built using other metrics, such as book value, dividend yield or volatility, in order to outperform the market. (For more, see: What's the Difference Between Alpha and Beta?).

Smart Beta is for investors who believe that markets are inefficient in very specific ways, and that they can identify factors with positive risk-adjusted returns,” Ronald Kahn and Michael Lemmon, strategists with BlackRock, Inc. (BLK), wrote in a 2014 white paper. They added, “smart beta strategies can also appeal to investors who would normally invest in active strategies, but whose fund size is very large compared to the capacity of most active strategies.”


Indeed the funds are very popular with institutions who use them for cheap exposure to desired characteristics, as well as with individual investors who are trying to save money on fees. (For more, see: Choosing the Right ETF Index to Reach Your Goals).

The current smart beta ETF assets are valued at $478 billion worldwide according to Mornigstar, and are estimated by BlackRock to reach $1 trillion and $2.4 trillion by 2020 and 2025 respectively. Andrew Ang, Head of Factor Investing Strategies at BlackRock said to Business Wire the rise of smart beta is accelerated by advanced in technology and data analytics, and is making investment solutions once only available to large institutions within reach for all investors. 


One idea behind smart-beta strategies is that they can command higher fees than strictly passive investing strategies that put ETFs on the map, while still undercutting actively-managed funds. A smart beta ETF can have fees up to three times as high as an market-cap weighted index ETF, however the fees are still considerably lower than actively managed funds. (For more, see: Active ETFs: Higher Cost vs. Added Value). 

Investors may also face higher trading costs than other ETFs. The reason is that smart-beta is still relatively new, may be small in size and often used as a buy-and-hold investment which can all mean low trading volume and wider bid-ask spreads, Morningstar's report said.

The Bottom Line

Financial advisors and clients have to assess smart-beta funds much as they would evaluate actively-traded products. Instead of being simple bets on a given index, the funds represent conscious decisions to pursue specific strategies, whether it’s concentrating on companies that pay high dividends or businesses that tend to buy back a lot of stock. The smart-beta category is now too big to be any one thing. That makes it different than the ETF sector in general, whose core idea was that investors could choose a fund and virtually forget about it. Advisors who point clients toward these products will have to monitor them, much as they would keep an eye on an actively-managed fund focused on a specific industry or asset class. (For more, see: Actively-Managed ETFs: Risks and Benefits for Investors).

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