Smart Beta Can Enhance Investment Returns

Smart Beta is the investment concept of deviating from a normal market capitalization weighting in a portfolio. To define these terms, lets start with the basics:

Smart = intelligent, not dumb.

Beta = represents volatility in relation to the market.

Capitalization = relative value of a corporation based on outstanding shares and current price.

Example

Approximately 10% of US stocks are considered small caps in terms of capitalization (meaning they are not the Apples or Exxons of the market). So, a normal weighting scheme would place 10% of the US slice of the portfolio into dedicated small company stocks. This means the majority of the portfolio's US stocks are something much bigger, which we refer to as mid and large cap stocks.

There's nothing inherently wrong with market cap weighting. However, one challenge it does present is a return bias on the biggest companies. Market cap weighting gives the largest companies the largest impact on an investor's return. So, if a no name large cap corporation like News Corporation (the smallest capitalization stock in the S&P 500) achieves a 20% return, cap weighting means that return is only magnified by it's weight in the index, or 0.007332. This is like owning a race car but putting tractor tires on it.

For comparison, Apple is the largest constituent in the S&P 500 with a 3.648524 weighting, i.e., much more sway when determining which way the index winds blow.

Not A New Concept

Institutional investment managers have been tinkering with alternatives to market cap weighting for a few decades now, and some of the strategies have shown long term positive benefits compared to a conventional market capped weighted index. The current issue of the ETF Report ties Smart Beta factors to approximately 45% of all listed Exchanged Traded Funds (ETFs). That might be a stretch, but ok.

Two Flavors To Choose From

Today, Smart Beta comes in two varieties, risk management and market outperformance. Risk can be mitigated with Low Volatility stocks. Outperformance is associated with Small Company stocks, Quality stocks, and Value stocks. A last stock factor, Momentum, can be expressed in both Smart Beta varieties. I've written about some of these themes and their historical returns Previously.

Performance

The entire point of Smart Beta funds is to capture the broad, persistent drivers of return. We have enough historical data to identify and measure performance trends. Using a multi-factor approach to express Smart Beta, we've seen some compelling performance data*.

Portfolio Incorporation

Smart Beta strategies are usually packaged up and sold via ETFs. iShares is one of the bigger issuers, and they maintain a robust lineup of 45 different Smart Beta ETFs. However, make sure to use the full list at ETF.com to find the best strategy for you.

Two caveats to be aware of. First, there is some risk in Smart Beta becoming so popular the return premiums will evaporate. This may or may not happen, but so far evidence shows no slowing down even with all the new buzz. Second, the factors driving Smart Beta don't show up consistently each year. It takes long investment horizons, such as those greater than 5 years, to really allow these strategies to work for an investor. Don't freak out the next time small caps take a beating compared to large caps, it'll likely be a short term anomaly.

Ask For Help

Being shy could represent a missed opportunity. Ask your current financial advisor if you're currently exposed to Smart Beta factors. If no, ask why not?

As always, we're here to offer a 2nd opinion on incorporating new strategies into your portfolio. It's easier than you think! We can help you break down the fund(s) best suited for your goals and capacity for risk based on your current portfolio. Just email us to start a dialogue. You never even have to pick up the phone!

* Source: Factor Performance Tool, BlackRock, using data from MSCI. MSCI ACWI Diversified Multiple-Factor Index and MSCI ACWI used as index representations of investment portfolios. Index returns do not reflect management fees, transaction costs, or expenses. Investors cannot buy an index directly. Past performance is no guarantee of future results.

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