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Smart Beta: What You Should Know

5 Questions to Ask Before Investing in Smart Beta

Smart beta, strategic beta, alternative beta, advanced beta—these are some of the names used to describe a large and diverse group of passive investing strategies. What distinguishes them is their use of “alternative” approaches to screening and weighting securities.

“Alternative to what?” you might ask. A traditional index like the S&P 500® Index is basically a list of stocks ranked by market capitalization (market cap), or the total market value of the underlying company’s outstanding shares. This is determined by multiplying the stock price by the number of shares in the market. Thus the most valuable companies will receive the largest weightings.

Investing strategies based on such indexes follow a similar logic. If the largest-cap stock accounts for 5% of a market-cap index, then a strategy based on that index will have a 5% allocation to that stock.

Smart beta strategies use other methods to rank investments. Some screen stocks based on “fundamental” factors such as the underlying companies’ sales, cash flows and dividends-plus-buybacks. Stocks with better fundamental scores will rank higher and get larger portfolio weightings. Some strategies give the least volatile stocks the largest weightings. Others give all the stocks in a market-cap index an equal weighting, which can tilt the strategy toward stocks with lower market cap than those at the top of the list. There are many different styles—and they all ignore traditional market-cap weightings.

Why? That depends on the strategy. Some seek higher returns than market-cap strategies, after allowing for risk. (After all, market-cap indexes are typically the yardsticks used to measure market performance, so a market-cap strategy will generally just replicate whatever the market is doing.) Other smart beta strategies aim for less volatility.

“Not all smart beta strategies are created equal,” says Anthony Davidow, Asset Allocation Strategist at the Schwab Center for Financial Research. “Depending upon the weighting methodology, investors may achieve very different results over time.”

Investors considering a smart beta strategy should start by asking these five questions:

1. What is the strategy trying to achieve?

The smart beta universe is broad, deep and diverse, so investors should be clear about what a particular strategy seeks to achieve, and how it aims to achieve it.

Morningstar estimates there are now more than 900 different exchange-traded products based on such strategies, and it groups them in three buckets: return-oriented strategies, risk-oriented strategies and other.

Chart 1: Table 1: Smart beta classifications

As the table shows, the strategies within each classification can vary widely. To pick just a few:

  • Dividend-screened/-weighted strategies rank stocks by dividend yield.
  • Fundamentals strategies rank and weight stocks using the fundamental factors as referenced above. Note: There may be differences among fundamental index strategies depending upon the factors used.
  • Momentum strategies rank stocks by recent price appreciation, with a focus on fast risers.
  • Minimum volatility/variance strategies focus on less volatile stocks.

Each strategy focuses on a particular attribute or set of attributes, and whether you’re looking for potential market-beating returns, lower volatility or increased diversification, you should be able to find one that meets your needs.

2. What is the underlying index?

Smart beta strategies are generally passive investments, meaning they attempt to track the performance of a particular index. Knowing the index on which a strategy is based can give you a sense of which securities it will invest in.

One simple way to illustrate this is to imagine two equal-weight strategies, one tracking the S&P 500 Equal Weight Index and another tracking the Russell 1000® Equal Weight Index. Both strategies would offer broad exposure to the market. However, where the former strategy might invest in all 500 stocks in the S&P 500 (with each stock having a 0.2% weighting), the latter might try to include all 1,000 of the stocks in the Russell 1000 (with each stock having a 0.1% weighting). As you might expect, such differences—which apply no matter what type of strategy you’re considering—can affect performance.

3. What are the sector allocations?

Smart beta strategies generally employ a rules-driven approach, wherein the weighting methodology determines what investments are included and in what proportion. One outcome of this approach is that some strategies might be more exposed to certain sectors than others.

The table below shows how seven different smart beta strategies compare with two market-cap indexes in terms of sector exposure. The PowerShares S&P 500 Low Volatility strategy demonstrates how a particular weighting methodology can result in different sector exposures. It has a relatively large exposure to the financials, consumer staples and utilities sectors. Historically, these sectors have been less volatile than some others.

Chart 2: Table 2: Sector allocations (%)

Again, this shouldn’t be taken to mean a particular strategy is betting on a certain sector, as an active fund manager might. Rather, if a strategy gives low-volatility stocks a higher weighting, and the financial, consumer staples and utilities sectors have all tended to be less volatile, then the strategy might end up with larger weightings in those sectors. And the sector allocations can change, so if volatility picked up in one of them, its weighting in a low-volatility index would likely shrink.

The bottom line for investors is to make sure they understand their sector exposure; that way they can avoid any unintended concentrations in particular parts of the market.

4. What is the strategy’s market-cap breakdown?

As with sector weightings, different smart beta strategies can result in varying exposure to different-size companies. For example, the Guggenheim S&P 500 Equal Weight ETF has more mid-cap exposure than the other strategies listed here, which is a result of giving all 500 companies in the S&P 500 equal representation. Meanwhile, the fundamentally weighted PowerShares FTSE RAFI US 1000 Portfolio has an allocation over 5% to small- and micro-cap stocks, which is a byproduct of its method of ranking stocks by a company’s financial measures like book value, cash flow, sales and dividends.

Again, investors should make sure they understand how a given strategy might lead to more exposure to certain parts of the market.

Chart 3: Table 3: Market capitalization and style (%)

5. What is the allocation across value, growth and core stocks?

Investors should also be aware of how different strategies can lead to concentrations in different kinds of stocks.

  • Value stocks are generally those considered undervalued based on economic factors.
  • Growth stocks are generally those considered highly valued because of expectations that earnings will rise sharply in the future.
  • Core stocks exhibit both value and growth characteristics.

The table above shows how certain strategies can result in different exposures. For example, the three strategies that look at different fundamentals—the Schwab Fundamental U.S. Large Company, PowerShares FTSE RAFI US 1000 Portfolio and WisdomTree Large Cap Dividend Fund—all have relatively more exposure to value stocks, as might be expected given their strategies’ focus.

Meanwhile, the iShares MSCI USA Momentum Factor has a nearly 68% allocation to growth stocks, which makes sense given that momentum and growth tend to be related.

Look before leaping

The rise of smart beta strategies has given investors new ways to structure their portfolios using alternative measures of value. Our view is that smart beta and market-cap strategies can complement one another, and that including both types of strategies in a portfolio can help smooth results over time. For example, investing in both fundamentals-focused and market-cap strategies can be a way to add diversification.  But as the examples above show, smart beta strategies may aim for very different goals, and even similar-sounding strategies can produce different results.

There is a great deal of variability across the smart beta universe,” says Anthony. “It’s important to spend the time to know what you own—and how you own it.”

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Important Disclosures

Investors should consider carefully information contained in the prospectus, including investment objectives, risks, charges and expenses. You can request a prospectus by calling Schwab at 800-435-4000. Please read the prospectus carefully before investing.

Investment returns will fluctuate and are subject to market volatility, so that an investor's shares, when redeemed or sold, may be worth more or less than their original cost. Unlike mutual funds, shares of exchange-traded funds (ETFs) are not individually redeemable directly with the ETF. Shares are bought and sold at market price, which may be higher or lower than the net asset value (NAV).

Past performance is no guarantee of future results.

Diversification strategies do not ensure a profit and do not protect against losses in declining markets.

All fund names and data shown above are for illustrative purposes only and are not a recommendation, offer to sell, or a solicitation of an offer to buy any security. Supporting documentation for any claims or statistical information is available upon request.

The S&P 500® Index is a market-capitalization-weighted index comprising 500 widely traded stocks chosen for market size, liquidity and industry group representation.

The Russell 1000® Index measures the performance of the large-cap segment of the U.S. equity universe. It is a subset of the Russell 3000® Index and includes approximately 1,000 of the largest securities based on a combination of their market cap and current index membership.

Indexes are unmanaged, do not incur management fees, costs and expenses, and cannot be invested in directly.

The Russell 1000® Growth Index contains those Russell 1000® securities with a greater-than-average growth orientation.

Schwab Intelligent Portfolios is made available through Schwab Wealth Investment Advisory, Inc. ("SWIA"), a registered investment adviser. Portfolio management services are provided by Charles Schwab Investment Advisory, Inc. ("CSIA"). SWIA and CSIA are affiliates of Charles Schwab & Co., Inc. ("Schwab") and subsidiaries of The Charles Schwab Corporation.

Schwab ETFs are distributed by SEI Investments Distribution Co. (SIDCO). SIDCO is not affiliated with The Charles Schwab Corporation or any of its affiliates.

©2016 Charles Schwab & Co., Inc. All rights reserved. Member SIPC.


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