True Or False? Analyzing 5 Common Myths About Smart Beta Funds

“Smart beta” is the title given to a set of investment strategies that have been gaining popularity in the investment industry. Being in the middle ground between active and passive investing, and closely related with factor investing, smart beta funds can lead to misconceptions. In this article, we decipher common myths in this buzzword.

Smart beta funds are index funds

Smart beta funds are not traditional index funds because they do not aim to mimic the stock market. To mimic the stock market, traditional index funds typically have all the stocks of the stock market and the securities will be weighted in the index by their market capitalization. Smart beta funds are distinguishable from traditional index funds because they apply different index construction rules.

In traditional indexes, each stock has its weight given by market capitalization; that is the market price times the total number of outstanding shares. The higher the price, the higher the weight on the index. Smart beta funds intentionally deviate from this weighting scheme because prices can incorporate a lot of market sentiment. Financial markets’ history has many episodes where investors’ valuation is not rational, the so- called “irrational exuberance.”  Popular stocks become overvalued, meaning that the price is high compared with information in the fundamentals. The problem comes when the market fad ends, many times with a bubble burst, and stock prices drop severely.

Because popular stocks have a high weight in the index, the index then has large drawdowns and investors suffer large losses. Therefore, a weighting scheme that is not correlated with prices gets the portfolio return disconnected from fluctuations in market sentiment and performance is enhanced in case of market downturn. Thus, the idea of protection against fluctuations of market sentiment draw the attention of investors concerned with the effects of market fads.

Smart beta is a new concept

Smart beta is not a new concept. Academic studies have shown over the years that securities with certain characteristics provide higher returns. These characteristics shared by stocks are named “factors.”  In other words, “factors” are understood to be drivers of returns and explain why some securities offer higher returns than others do. Factor investing is a style of investing where the portfolio is constructed to capture the returns coming from a certain factor.

Smart beta funds explore these insights coming from academic works and therefore they relate with factor investing because the weighting scheme intentionally favors certain features of stocks to enhance returns.

Smart beta funds believe that markets are not efficient and they can generate alpha

“Alpha” and “beta” are both are financial jargon. The return of an investment can be generated because it has more risk. “Beta” measures the level of risk of an investment. “Alpha” can loosely be defined as the difference between the real return and the return expected for that level of risk. Therefore, “alpha” measures the value creation or destruction of the portfolio manager of a fund.

A second important reason why a portfolio manager might want to deviate from a typical stock market index is because of the belief that markets are not efficient and there are investment opportunities to be exploited. Then, the portfolio manager would try to identify mispriced securities that can provide “alpha” to include them in the portfolio.

Smart beta funds are not driven by beliefs about market inefficiency. They believe that investments can get rewards for holding securities with certain factors because “factors“drive returns. Thus, the weighting scheme will lean towards those factors that they believe will enhance the returns of the portfolio instead of market capitalization.

Smart beta funds do not have risks.

Despite the benefit of “smart” in the name, these funds do have risks. As any financial investment, their return is uncertain and they can underperform.  Although, historically, factor strategies have provided positive returns, it is also true that their return changes with time, creating uncertainty.

Smart fund investors might face additional drawbacks such as higher costs. While the market capitalization scheme automatically rebalances, smart beta funds regularly need to rebalance the portfolio to adjust to factor exposure. This implies higher turnover than traditional index funds, and therefore higher transaction costs and lower returns.

Moreover, in market capitalization weighting, the index is concentrated in large and popular stocks. In the smart beta approach, some weighting schemes might be concentrated in some industries or in illiquid assets, which increases the risk. This can be overcome by imposing diversification rules in the selection criteria. In fact, many smart beta funds provide diversification across factors.

Nowadays, because of the soaring popularity of smart beta approach, many of the stocks that are targeted by these funds have become expensive, which means lower returns. Therefore, popularity has worked against the strategy.

Smart beta is a unique type.

Although they share a unique label, there are as many types of smart beta approaches as there can be different alternative weighting schemes and different groups of securities. They are classified in some substyles, to give a few examples:

In fundamental weighting schemes funds weigh stocks using fundamental variables such as earnings, sales, or operating cash flows. Thus, stocks from companies with good fundamental metrics are then overweighed in the portfolio.

In the factor weighting schemes, market-cap weighting is replaced by a weighting scheme that emphasizes certain factors that have performed well historically, such as momentum, value, size or dividend yield. These funds can target either one factor alone (single factor) or they can target several factors at the same time (multifactor).

Another popular risk-weighting scheme is inverse volatility: each asset is weighted in inverse proportion to its volatility. The strategy penalizes high-volatility assets, even if they are negatively correlated to other assets.

Overall, the only thing the weighting schemes have in common is that they do not rely on market capitalization.

Written by Sofia Ramos, Associate Professor at ESSEC Business School (Paris-Singapore).

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