Investors can select from an ever-increasing number of funds based on smart beta indexing methodologies. On May 12, 2016, BlackRock Inc. (NYSE: BLK) announced the launch of nine new iShares Edge smart beta exchange-traded funds (ETFs).

Smart beta avoids weighting index components according to price. Instead, weightings of component stocks are based on fundamentals, risk, or a combination of both. Beyond that, some smart beta systems incorporate quality metrics, such as earnings growth or consistently strong quarterly earnings.

Passive Management

Many mutual funds and ETFs track a particular index, allowing for passive management and lower administrative costs. Because the portfolio of a passive fund matches a particular index, there is no need for fund managers to devise market-beating investment strategies. The reduced management costs for a passive ETF can result in an expense ratio as low as 0.03%, as is the case with the Schwab U.S. Broad Market ETF (NYSEARCA: SCHB).

Passive funds designed to track broad market indexes generally experience volatility or systemic risk, measured as beta, to a similar degree as the volatility of the market as a whole. For example, SCHB has a beta factor of 1.01. Because the beta for the stock market as a whole is 1, SCHB experiences approximately the same volatility as the broader market.

Critics of passive management assert that most passive funds track a capitalization-weighted index with an assigned percentage of index weight to each component, representing the security’s proportional share of the total dollar amount invested in all of the index components.

Market cap weighting is basically a popularity contest, wherein the most popular stocks in the index receive the most weight. This can cause the prices of top-weighted stocks to become too expensive with respect to their fundamentals. When one of these stocks has a quarterly earnings report that reveals that the stock's price is unjustified, the resulting selloff of that stock can impact the price of any fund that assigns a significant amount of portfolio weight to that holding. Market cap weighting gives additional weight to overpriced stocks and reduces weights for undervalued stocks.

Active Management

Active management benefits from the involvement of a fund manager who assigns portfolio weights based on strong fundamentals, whereas passive indexing allows market participants to rank stocks based on price. As a result, active management offers the opportunity to provide alpha because the return on investment is not a result of general movement in the greater market. A passive fund that accurately tracks its benchmark index has an alpha of 0 because there is no methodology in place to add (or reduce) the portfolio’s value.

The primary drawback to active management is the additional expense of employing an administrator or team to engage in risk management and conduct the necessary portfolio turnover to deliver returns.

Why Smart Beta Is Better

Smart beta combines the benefits of active management with the reduced expenses of passive management. Smart beta funds have a passive quality because they each track a customized index in the same manner as passive funds, in order to limit management expenses.

Asset management firms use different approaches toward alternative indexing methodologies. Although the specific weighting formula for an index might not be revealed, due to its proprietary nature, smart beta offers a degree of transparency because index originators disclose the factors and other data points, which forms the basis of each weighting scheme.

Rules-based methodologies define specific parameters for selecting and weighting component stocks. In contrast, active management is relatively opaque because there is no way to ascertain the extent to which intuition and unknown optimization techniques are used in weighting the portfolio holdings.

The wide variety of smart beta indexing methodologies includes techniques that weight component stocks according to such accounting metrics as dividend payments, revenue, book value, cash flow, reducing balance sheet debt and engaging in share repurchases. A greater number of factors help increase portfolio diversity. Use of quality factors, such as degree of earnings growth and consistency of positive quarterly earnings can increase the risk premium for investors.

Smart beta funds are useful tools for following a value investing strategy. Fundamentals-weighted indexes favor stocks with stronger fundamentals and weaker prices.

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