What is Smart Beta?

Navigating financial lexicon can be a tricky business. One of the more interesting terms to surface in recent years is “smart beta.” Smart beta sounds catchy and clever, but what does it mean?

Smart beta is an umbrella term to describe rules-based or thematic-based investing. Smart beta aims to achieve superior returns by identifying key drivers (or risk factors) of long-term investment returns and coming up with objective rules to invest accordingly. The key drivers can be categorised under two broad themes – macroeconomics and investment style.

Macroeconomic drivers can include a focus on certain fast-growing industries; a focus on emerging markets that are deemed to have high growth potential, such as the BRICS group (Brazil, Russia, India, China, and South Africa); asset classes that provide inflation hedges, such as natural resources, commodities, real estate, and gold; and much more.

A few examples of investment style drivers are value investing (identifying stocks with, say, low price-to-earnings ratios or low price-to-book ratios); momentum investing (identifying stocks whose prices have risen recently, with the idea that what has climbed in the past is likely to rise further); low volatility (identifying stocks that do not fluctuate as much as stock market indices), and more.

Unlike passive index funds, smart beta funds do not aim to replicate the returns and holdings of stock market indices. Instead, smart beta funds invest in stocks that are selected by following a set of objective and transparent rules.

For example, the S&P 500 index in the US weights its constituents (there are around 500 stocks in the index) by market capitalisation. A passive index fund tracking the S&P 500 would hold the exact same stocks as in the index, and weight them by market capitalisation in the same manner as well.

But, a smart beta fund could invest in exactly the same stocks – with a twist. It could, for example, weight the stocks equally instead of by market capitalisation, so all 500 stocks would each make up 0.2% of the smart beta fund. Or, the smart beta fund could weight the stocks by their dividend yields or PE ratios, for example.

Smart beta is a hybrid of active investing and passive investing. Smart beta funds allow investors to make investment decisions by evaluating the value of an investment strategy or a macroeconomic driver, rather than by assessing the competence of an active fund manager.

Still, whether smart beta can deliver its “smart” promise or is simply a clever marketing gimmick remains to be seen. Actively managed funds have faltered mainly because of higher fees and general poor performance. Smart beta funds tend to incur higher fees relative to passive index funds because there is still an element of active management in there (someone has to select the investment strategies or macroeconomic drivers that are used). Investors should assess how robust the rules underlying a smart beta fund are before venturing in.

For more investing insights and to keep up to date on the latest financial and stock market news, you can sign up for a FREE subscription to The Motley Fool's investing newsletter, Take Stock Singapore

Also, like us on Facebook to follow our latest hot articles. The Motley Fool's purpose is to help the world invest, better.

The information provided is for general information purposes only and is not intended to be personalised investment or financial advice.