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Getting Smart on Beta

“Smart beta” is the flashy name for an array of investment strategies that have attributes of both active and passive management. On the one hand, these strategies attempt to deliver better returns or lower volatility than a given benchmark, much like an active manager would. On the other, they can also offer some of the tax and cost advantages of passive management.

These strategies—also known as “strategic beta” or “alternative beta”—have become increasingly popular in recent years. The value of assets in exchange-traded funds (ETFs) pursuing smart beta strategies grew from around $200 billion at the start of 2013 to $400 billion by the end of 2014.1

Some of these strategies are worth considering. But before adopting a smart beta strategy, it’s important to understand how loosely defined the category is, says Tony Davidow, Vice President, Alternative Beta and Asset Allocation Strategist at the Schwab Center for Financial Research.

“There are now many different types of strategies calling themselves smart beta,” Tony says. “But not all smart beta strategies are alike and investors need to know what they’re buying.”

Here, we’ll take a closer look at how these strategies can differ and provide some guidelines to help you determine if they might be a good fit in your portfolio.

Like traditional passive index strategies, smart beta strategies track indexes of stocks or bonds. Where they differ is in the methodologies they use to weight individual securities.

A look at market cap

Traditionally, the most common way to assemble an index has been to look at market capitalization, which is calculated by multiplying the price of each individual stock by its number of shares outstanding. Using this methodology, the largest companies have the largest weight in the index. Some well-known market-cap indexes are the S&P 500® Index, Russell 1000® Index and MSCI EAFE Index.

If the biggest stocks in an index are among the top performers, having an outsized exposure to them is ideal. But what if the biggest stocks aren’t the best performers?

Different flavors of smart beta

To address this possibility, smart beta strategies screen and weight securities using methods aimed at delivering different risk or return characteristics.

“Smart beta strategies essentially are trying to break the reliance on price when it comes to weightings,” Tony says. “These strategies are designed in different ways and many try to capture outperformance by weighting holdings based on relative attractiveness and not just sheer size.”

A few of the more popular approaches to smart beta are fundamental, equal weighting and low-volatility strategies.

Fundamental strategies weight securities by financial measures such as sales, cash flow and dividends plus buybacks. A market-cap index and fundamentally weighted index will typically own similar stocks, but the proportions can be quite different.

For example, the tables below show the top 10 holdings of the Russell Fundamental U.S. Large Company Index and the market-cap-based Russell 1000 Index. You’ll notice that Exxon Mobil Corp. has a much heavier weighting in the fundamentally weighted index than in the market-cap index. This is because the fundamentally weighted index’s methodology assigns more value to the company’s sales, cash flow and dividend payment characteristics.

Another popular smart beta strategy is to weight all the stocks in an index equally, meaning all companies, whether big or small, have the same representation in a portfolio. Proponents of this approach say giving every company in an index an equal weighting allows smaller and potentially faster-growing companies to contribute more to a strategy’s performance.

Other strategies vary holdings based on volatility, aiming to reduce wide up or down swings. For example, a strategy targeting low-volatility companies may overweight sectors like utilities and consumer staples, which historically have been less volatile than other sectors.

Choose carefully

Tony says demand for innovative indexes has led to a surge in smart beta strategies—but quality hasn’t always kept pace with quantity.

Historically, smart beta strategies have tended to have higher tracking errors than market-cap strategies, meaning they haven’t always been as successful in mirroring the benchmarks they’re supposed to follow. Market-cap strategies provide little or no tracking error. The benefit of having strategies with low tracking error is that you know what type of exposure you’re getting when you buy one.

Fees are also important. Smart beta strategies generally offer lower costs than most actively managed strategies, but they are typically more expensive than market-cap strategies.

Take a balanced approach

No strategy performs well in every market environment. The Schwab Center for Financial Research has found that combining market-cap strategies with the appropriate smart beta strategies can help smooth a portfolio’s performance.

“Because of the different weighting methodologies, the two types of strategy perform quite differently over time,” Tony says. “What we’ve seen is one holding tends to complement the other and combining them both in a portfolio is likely to produce better risk-adjusted results.”

Tony says most investors should consider using smart beta strategies to provide some diversification from traditional market-cap index strategies. He suggests following these steps to decide whether a strategy is right for you.

  • Research the underlying methodology. Determine how the strategy is weighting securities and which index it is using.
  • Check for unwanted bias. See if the strategy introduces certain biases or bets through its weighting methodologies—for example, does it provide more exposure to certain sectors than others? Make sure you’re comfortable with the allocation.
  • Monitor the track record. Though many of these strategies are new, it’s worth checking to see how they have performed—and if they have lived up to expectations.

Alpha vs. beta

Fund companies often throw around the terms “alpha” and “beta” when naming new strategies and there’s a big difference between them. Alpha measures the extra return an investment delivers over a benchmark, while beta measures an investment’s risk in comparison to the market as a whole. Some “smart beta” strategies look to provide both in that they seek to minimize volatility while enhancing returns.

Awash in Data
Part of the Plan

Important disclosures

Past performance is no guarantee of future results.

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

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.

The MSCI EAFE Index is recognized as the pre-eminent benchmark in the United States to measure international equity performance. It comprises the MSCI country indexes that represent developed markets outside of North America: Europe, Australasia and the Far East.

The Russell Fundamental U.S. Large Company Index ranks companies in the Russell 3000 Index by fundamental measures of size and tracks the performance of those companies whose fundamental scores are in the top 87.5% of the Russell 3000 Index. The index uses a partial quarterly reconstitution methodology in which the index is split into four equal segments at the annual reconstitution and each segment is then rebalanced on a rolling quarterly basis. Performance includes reinvestment of dividends.

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

Russell Investments and Research Affiliates, LLC have entered into a strategic alliance with respect to the Russell Fundamental Index Series. Subject to Research Affiliates’ intellectual property rights in certain content, Russell Investments is the owner of all copyrights related to the Russell Fundamental Index Series. Russell Investments and Research Affiliates jointly own all trademark and service mark rights in and to the Russell Fundamental Index Series. Charles Schwab & Co., Inc. is not affiliated with Russell Investments or Research Affiliates. The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.


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