The first index-based mutual funds and exchange-traded funds (ETFs) were designed to mimic popular indexes such as the S&P 500® Index and the Russell 2000® Index, which screen and rank stocks based on the total stock market value of their shares. But now some investors have begun to wonder: Are there better ways to gain exposure to various segments of the market?
Smart beta strategies—also known as strategic beta—seek a different kind of market exposure by screening and weighting securities based on factors other than market capitalization. It’s an innovation that provides a way to capture many of the benefits of traditional index investing while also harnessing some of the market-beating returns that can be associated with active investment managers. And as the bull market in U.S. stocks matures, it seems that fundamental strategies—smart beta strategies that focus on companies with strong economic fundamentals—are likely to be rewarded.
How strategic beta works
Unlike market-cap strategies, in which the largest companies have the greatest weight, smart beta strategies seek to break the link with price and instead focus on weighting companies by other factors, such as sales or cash flow.
Understand that not all smart beta approaches are alike. Here are three of the most common.
- Fundamental, which screens and weights securities based on economic factors such as sales, cash flow and dividends plus buybacks
- Low volatility, which screens and weights securities based on historic volatility
- Equal weight, which provides the same weight to each security in an index
Among these, fundamental strategies have been a focus of research. Fundamental strategies were pioneered by Research Affiliates 10 years ago, and they’re based on rigorous analysis and studies that have found there is value in weighting securities based on more fundamental measures, such as sales and cash flow.
The Schwab Center for Financial Research has done extensive research on fundamental strategies as well. In analyzing the risk-adjusted results of a fundamentally weighted index versus a traditional market-cap index, we compared the spliced Russell Fundamental U.S. Large Company Index with the Russell 1000® Index from 2009 to the present. The spliced Russell fundamental index delivered an annualized return of 15.78% versus 14.31% for the Russell 1000, with reduced risk. The spliced Russell fundamental index uses data from the FTSE RAFE 1000 Index from January 2009 through September 2012 and the Russell Fundamental U.S. Large Company Index from October 2012 to June 2015.
A strategic appeal
Morningstar, which recently began tracking the growth of strategic beta, has introduced a new classification system. Today there are nearly 400 smart beta strategies accounting for more than $400 billion in assets, thanks in part to growing demand from both individual investors and institutions.
Schwab’s research on fundamentally weighted strategies shows that their performance compares favorably with both market-cap strategies and active managers. These strategies won’t outperform in all market environments, and they aren’t immune to market losses—but over the long run they have delivered excess returns.
And while many smart beta and fundamental funds may have higher operating expense ratios than traditional ETFs or index funds, their expenses are still substantially lower than those of most actively managed funds.
Building better portfolios
We believe in the merits of combining active management, market-cap indexes and fundamentally weighted strategies. Each approach can play a role in your portfolio.
These four key levers can help you gauge how useful these strategies may be in your portfolio.
- Tracking error, which measures the difference between a fund’s holdings compared with its benchmark
- Loss aversion, which addresses your relative aversion to the loss of your principal investment
- Alpha, or excess returns relative to a benchmark
- Cost, or the overall expenses associated with owning an investment, including fees, trading charges, and any other costs
Here’s how fundamentally weighted strategies compare with other strategies on those elements.
Because active managers often have the option of protecting on the downside, actively managed funds can still play a role in your portfolio, even if you’re inclined toward index funds. Certain active managers may add value by playing defense and by changing their portfolios when things get difficult.
Should you consider smart beta strategies in your portfolio? By capturing many of the positive attributes of traditional market-cap indexes and active management at a relatively low cost, smart beta strategies represent an evolutionary step forward.
Another compelling rationale stems from today’s market environment: We’re in the sixth year of a secular bull market. In the early stages of a bull market, a rising tide tends to lift all boats—so merely being exposed to the markets meant most portfolios grew during those stages. For example, market-cap indexes often exhibit “momentum” in rising market conditions. And market-cap indexes reward popular stocks, such as Apple, Amazon, Facebook and Google.
But as the U.S. market enters a more mature phase, we believe companies with strong fundamentals are likely to be rewarded—and companies with extended valuations are likely to be scrutinized. Fundamental strategies tend to have a value tilt based on their screening and weighting methodologies, as described above. So fundamentally weighted indexes focus on companies with strong fundamentals and favorable valuations, such as Exxon, Chevron, AT&T and Microsoft.
For investors interested in smart beta strategies, now may be a good time to evaluate which may add the most value to their portfolios.