Smart beta is a big deal in the exchange-traded fund (ETF) world. Whether you call it smart beta, factor investing or you use Morningstar Inc.'s term “strategic beta” these ETF strategies are all the rage. Most smart beta strategies are based off of a twist on a mainstream passive index. But are these strategies really another version of indexing or are they active management?

Factor Investing

Factor investing requires investors to take into account an increased level of granularity when choosing securities—specifically, more granular than asset class. Common factors reviewed in factor investing include style, size and risk. Here are some examples of ETFs using five main smart beta factors: 

  • Value - Invesco S&P 500 Pure Value ETF (RPV) invests in the cheapest one-third of the stocks in the S&P 500 Index based upon metrics such as their price-earnings ratio. Additionally, the fund weights the holdings of their value characteristics. This ETF takes a slice of the index and applies its own metrics in order to try to beat the index and its large value peers.
  • Size - The iShares Edge MSCI USA Size Factor ETF (SIZE) “seeks to track the investment results of an index composed of U.S. large and mid-cap stocks with relatively smaller average market capitalization,” according to the iShares website. This ETF tracks an index constructed by MSCI that reweights the top 600 stocks in the large and mid-cap universe periodically to give the stocks in this universe a higher weighting.
  • Momentum - iShares Edge MSCI USA Momentum Factor ETF (MTUM) “… targets large and mid-cap stocks with strong risk-adjusted price momentum,” according to Morningstar. Their analysis also mentions that the specialty index constructed for this ETF by MSCI takes risk-adjusted momentum factors into account, which differs from most momentum investing strategies. Additionally, its only rebalances the index semi-annually, versus monthly, for most momentum strategies. (For more, see: Smart Beta ETFs Strategies.)
  • Low Volatility - Invesco S&P 500 Low Volatility ETF (SPLV) “consists of the 100 securities from the S&P 500 with the lowest realized volatility over the past 12 months,” according to the Invesco website.
  • High Quality - Schwab US Dividend Equity ETF (SCHD) tracks the Dow Jones U.S. Dividend 100 Index, focused on stocks with consistent dividends. 

As you read through the descriptions of these ETFs and other smart beta ETFs, you are struck by the fact that these are not just you plain-vanilla market-cap weighted ETFs on the order of a traditional index ETF like the widely-held SPDR S&P 500 ETF (SPY). It also seems that even following these benchmarks takes some work. This is more than just tracking the 500 largest U.S. stocks or 2,000 small cap stocks. In most cases, smart beta ETFs have higher expense ratios than plain-vanilla index ETFs.

A Combination of Active and Passive?

Smart beta ETFs generally passively follow a unique index or benchmark that was constructed for the fund. These are generally rules-based and often require some sort of periodic reconstituting or reconfiguring to rebalance. These synthetic benchmarks are mostly constructed in the “lab” and tested via rebalancing. Some have a decent amount of history, others are new and have not been tested over a full stock market cycle.

Altaf Kassam, head of MSCI’s Index Applied Research, has said the following about factor investing: “It is a third way of investing: between active and passive. It does not replace market-cap passive investing, nor does it fully replace active management. Factor investing has some of the features of passive investing, such as investing systematically at low cost. It also has some of the features of active management by aiming to generate returns above the market cap-weighted index."

Why Smart Beta?

In recent years, passive index investing has grown in popularity. Many index funds and ETFs routinely outperform the majority of the active managers in their asset class.

Investors and ETF providers are a competitive group and the concept of smart beta arose out of a desire to beat plain-vanilla indexing with the low costs and passive nature of index funds. One of the things investors and financial advisors need to remember with smart beta is that the strategies or factors can lag over long periods of time even if they ultimately prove to be superior over the long haul.

A Long-Term Thing

Morningstar’s John Rekenthaler showed that value, size and momentum factors delivered superior relative performance from 1964-1981. This outperformance continued from 1981-2009 for value and momentum-based investing. In the period since the market bottom in early 2009 through the end of 2015, however, all three factors have underperformed. These are of course generalizations, but this does illustrate the long-term nature of factor investing.

The Bottom Line

Is smart beta a form of indexing or active management? For indexing purists, they would probably say the latter. Those that view it as more of a hybrid of the two are probably right, at least to some extent.