Smart Beta: The Alternative Investment Strategy

Before we dissect the anatomy of smart beta, let’s first explain what an investment strategy is.

An investment strategy is a set of rules, behaviors or procedures that help guide an investor's choice of investment portfolio, and will depend on an investor's goals and the risks they’re willing to take.

So, simple to understand what they do, but a little more tricky understanding how each one works.

Now, smart beta is an alternative investment strategy that aims to increase returns or minimize risks. Instead of measuring investments against conventional indexes, like S&P 500, this strategy weighs investments against factors like volatility and dividends. Otherwise known as non-market fundamental value measures.

Sounds complicated, but it’s actually a pretty simple strategy and one that’s growing in popularity. Between 2012 and 2017, the value of smart beta funds grew at almost 30% annually, and surpassed $1 trillion in assets in 2017.

Why the name, Smart Beta?

A new finance model led to the addition of the Greek letters ‘alpha’ and ‘beta’ in investment lexicon. So, to understand smart beta investment strategies, first need to get into the mysterious world of these Greek terms.

Alpha is a concept that describes the excess return obtained from an investment portfolio, over the return that is already expected to produce from being on the market. The portfolio manager’s ability to choose the right securities that perform better on the market is connotated with the term ‘Alpha’.

Read also: A simple guide to start investing in stocks

On the other hand, Beta is a measure of the volatility of a security in comparison to the market. For example, a stock with a beta value of 1 will have identical price swings than the market’s. If the market has a rise of 15%, the stock will increase its price by 15%, but if the market falls 10%, the stock will lose the same amount.

Stocks with a beta value above 1 will show more volatility than the overall market, while stocks with a beta below 1 will be less volatile.

Smart beta strategies structure an investment model that quantifies the risk of a security or portfolio, and converts that risk into expected return.

Smart beta funds seek to achieve higher returns, hence the smarter part, by buying a larger proportion of stocks based on the criteria that the asset manager thinks will lead to outperformance, without increasing risk – the beta part.

What about Smart Beta ETFs?

A Smart Beta ETF is a type of Exchange-Traded Fund that takes into account factors such as volatility, value and size to be based on alternative index construction rules.

These funds are a great choice if you are looking to minimize risk because they use smart beta strategies to maximize your return by focusing on areas of the market that can be productive.

The general purpose of Smart Beta ETFs is to lower the risk of the portfolio and increase its returns by maximizing dividends.

However, it is hard to know if they will have a good performance with large investments because they still are a relatively new investing method so they are not based on enough actual data.

Should you risk all on smart beta funds?

Let’s look at the evidence. A study by Invesco (an independent investment management company) shows that over a period of 25 years (1991–2015), smart beta investment strategies outperformed the S&P 500 by between 0.80% and 2.50%.

That’s pretty darn impressive, especially when you consider the fact that beating the market over a long period of time is thought by many to be impossible.

Keep in mind that smart beta is based on past performance. So any changes in the future could see smart beta funds declining relative to the general market.