Over the past five years, the volume of assets invested in smart beta ETFs has risen at a compound annual growth rate of 21.5 per cent to $857 billion according to data from ETFGI, a London-based consultancy. And that is fast. But we should not follow the herd, we are different, must be irrational exuberance right? Not always. Anyways, we should analyse every strategy and choose or even make our own.
We are all familiar with index investing (think passive management), and indices are market-cap weighted, why though?, companies with high prices (think FANG stocks) are given higher weights and cheaper companies are given lower weights, buy high sell low? May seem a bit counter-intuitive to some, which I think gave birth to the concept of 'factor investing' and smart beta in addition to dissatisfaction with traditional active-passive approaches. Someone wanted a middle ground. Thus, in a smart beta strategy, portfolio holdings are distributed not using its market cap, but using some factors. A 'factor' is simply an attribute that may drive risk or returns like beta, value, size, price momentum and low risk among others. For example, stocks of companies that generate superior profits, strong balance sheets, and stable cash flows are considered high quality, and tend to outperform the market over time, which could be some of the factors. An example of such a fund is the S&P 500 low volatility fund which is exactly what it sounds like. They mechanically follow indices and change weighting approaches which is still cheaper than actively managed funds.
Seems like a simple good strategy. But with simple comes consequences, these strategies can over-simplify the portfolio construction process. Managers need to ensure that the appropriate factors are carefully implemented with underlying economic rationale: beware the poorly constructed portfolio.
Finally, if a strategy that blends components of active and passive investing appeals to you, you might want to consider investing in smart beta strategies. Before investing, be sure to read the fund’s prospectus carefully to ensure you understand the risks fully.
Courtesy- ft.com, fidelity.com, london.edu
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