The buzz on Smart Beta

August 15, 2014

Financial publication Barron’s reported recently that a 1 trillion mutual fund company had filed with the SEC to offer several actively managed Exchange Traded Funds, joining major money management firms State Street, Blackrock, Fidelity, and Vanguard. This is significant since 80 percent of the firm's assets come from front-end fee mutual funds, while ETFs are famous for ultra-low fees. The chief reason for their low cost is minimal trading and low portfolio turnover, not attributes of active management.

Most ETFs are passively managed Index Funds. The return on an ETF that mimics the S&P 500 Index, for example, is pretty much the same as that index. Many of the new actively managed ETFs are referred to as “Smart Beta,” which Morningstar reports represent 18 percent of the 1.7 trillion ETF universe.

In basic investment vernacular terms, Smart Beta refers to a tweaking of the structure of an index like the S&P 500. Most Smart Beta strategies are relatively simplistic compared to active investment management strategies. One common tweak is to change the weighting of the positions in the index from the traditional market capitalization (Cap Weight), to an Equal Weight; meaning the 500 companies are equally represented in the index. Other Smart Beta strategies involve tilting or biasing a portfolio’s exposure toward market factors such as low volatility, valuation, or quality. Others may target book value, revenue, or dividends, which has rewarded investors in the past.

I believe promotion of Smart Beta ETFs is more of a marketing ploy, a lifeline for the investment industry’s active managers who have steadily ceded market share to passive investment management. Traditionally, active investment management has referred to stock selection and market timing. Every day you read where a market maven has devised the perfect strategic or enhanced beta product. That’s always been a claim of active management. To define: Beta is a mathematical measure of the sensitivity of a return on a portfolio or stock, compared with rates of return on the market as a whole. Beta is represented by the number 1.00 and is considered “the market." A number above 1.00 means the position has greater volatility (risk) than the market. Smart Beta then is supposed to deliver better market returns, using certain market factors to increase the return delivered by the market or an index. There is some truth in that the basic indexes aren’t designed to provide “excess” return.

Despite the fact all empirical studies and market research I’ve read validate passive investment management has consistently beaten its active management cousin, I believe certain Smart Beta strategies have a place in an investment portfolio as long as costs justify outperformance. Smart Beta could complement Core Passive Positions falling somewhere between traditional active and passive strategies. I have combined Cap and Equal Weighted position in most portfolios. The Cap Weighted S&P 500 ETF Index returned 24 percent on a one-year basis as of July 1, 2014 while its Equal Weight cousin returned 26 percent over the same period.

I regularly underweight or overweight the nine business sectors of the S&P 500 as appropriate to the economic cycle. When the financial sector was underperforming in 2008, I underweighted in portfolios; and this year when energy and utilities were performing well, I overweighted those sectors with favorable results. Smart Beta ETFs engineered to provide lower portfolio volatility have also proven strategically beneficial. Smart Beta strategies naturally involve additional portfolio rebalancing and higher turnover so cost is higher, but not as high as traditional actively managed portfolios.

John Boraski, MSFS, is a Registered Investment Advisor. Email; go to


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