If active managers are able to post returns in excess of passive, market-weighted benchmarks, it is only through the exposure to a limited set of factors, such as beta, value, size, price momentum and low risk.

The experience of many investors is that actively-managed funds have not consistently provided index-beating returns. With the support of academic research and popular media, investors have flocked to passively-managed index funds and ETFs.

Yet, it seems counter-intuitive that the world’s most sophisticated allocator of capital would passively place investment dollars on the sole basis of the percentage that a particular company may represent in an index at any given time, without regard to actual business results or future prospects.

Index funds have inherent drawbacks, such as overweighting stocks with high prices, and often having a high concentration in a small number of mega-cap stocks and sectors.

A middle ground, however, seems to be emerging out of this binary world of active versus passive, where an index approach is modified with active investing, based on some disciplined, rules-based framework that seeks to provide above-index returns and/or lower risk.

Smart Beta: The Future of Investing?

Smart beta is a general term for investment strategies that use mechanical index construction rules that differ from traditional market capitalization-based indices. Smart beta, or factor investing, attempts to profit from systematic factors or market inefficiencies in a straightforward and transparent manner that involves no human judgment once the framework is in place. Smart beta funds offer investors the potential for index outperformance at reasonable cost (though higher than an index fund).

A recent study analyzing the performance of passively-managed index funds and alternative index approaches found that “the alternative indices considered here would have produced a better risk-adjusted performance than could have been achieved by having a passive exposure to a market-capitalization weighted index.”¹

Their simplicity may be a disadvantage, however, as rigid rules may result in the sacrifice of portfolio efficiency, leading to large concentrations in individual stocks or sectors.  Smart beta runs the risk of becoming a victim of its own success, as its performance edge erodes as more and more investor dollars are directed toward these funds.

Smart beta has also become a more complex decision as some funds now blend factors to provide diversification against the poor performance of any particular factor at a given time, while other funds seek to time their investment in factors that may be undervalued and exiting factor strategies that may be overvalued.

History will decide if smart beta is the next stage in the evolution of investing or a passing fad. Like the many investment strategy innovations of the past, advisors will need to proceed with careful deliberation.

1. “An evaluation of alternative equity indices Part 1: Heuristic and optimized weighting schemes,” Andrew Clare, Nick Motson and Steve Thomas, March 2013

See referenced disclosure (2) (3) at https://blog-dev.americanportfolios.com/disclosures/