Over the past decade, there has been a shift from actively managed mutual funds to exchange-traded funds (ETFs). Now, a relatively new breed of ETFs that represents an evolution on classic indexing—sometimes called “strategic beta” or “smart beta”—is catching on. In fact, assets in U.S. strategic beta ETFs increased from around $100 billion in 2010 to about $500 billion today, according to Morningstar.
Unfortunately, the term “smart beta” has become something of a catch-all description, and it tends to obscure the differences among smart beta strategies. “Not all smart beta strategies are the same,” says Tony Davidow, alternative beta and asset allocation strategist at the Schwab Center for Financial Research. “One of the biggest challenges investors face is distinguishing among the various types of smart beta options and choosing a strategy that best suits their goals.”
Moving beyond market cap
Most major indexes (the S&P 500® and Russell 2000, for example) are market-capitalization (market-cap) weighted, meaning that the amount invested in each stock in a given index is determined by the size of the company. The bigger its market capitalization—that is, the total value of its outstanding shares—the larger a company’s weight in the index. When a stock’s growth outpaces the rest of the market, its relative weight within the index also rises.
A smart beta mutual fund or ETF is also index-based. However, rather than weight the holdings based on market-cap, smart beta funds break the link with price (size) and weight holdings based on other metrics.
Smart beta variations
While these strategies may seem new to many investors, institutions have been using them for years. The industry broadly groups many of these strategies together under the smart beta moniker, whereas Morningstar categorizes these strategies as “strategic beta” and breaks them down into three broad sub-categories: Return-Oriented, Risk-Oriented and Other.
And there are more than 845 strategic beta strategies in the Morningstar universe. A few popular ones include:
- Equal-Weight: Provides the same weight to every stock in a given index.
- Low-Volatility: Weights stocks based on their level of volatility over a specified period, such as one year.
- Momentum: Weights stocks based on their price momentum over a specified period.
- Quality: Weights stocks based on strong balance sheets (low debt), consistent earnings and high levels of profit measures such as return on equity.
- Fundamental: Weights stocks based on economic factors such as sales, cash flow, and dividends plus buybacks.
Different strategies, different performance
Tony studied the performance of these five smart beta strategies from 2008 through September 2017, comparing the yearly performance of each to the performance of a traditional market-cap-weighted index.
As you can probably guess, there is no single strategy that shines year in and year out. In 2015, momentum was the best performing strategy, as the market was driven higher by the FANG stocks—Facebook, Amazon, Netflix and Google (Alphabet). As investors began to pay attention to valuations, momentum lagged in 2016, and fundamental was the best performing strategy.
“The point is that not all smart beta strategies are created equally, and that means there will be performance differences in different types of markets,” says Tony.
Source: Schwab Center for Financial Research with data provided by Morningstar Direct. Data used from January 1, 2007 through December 31, 2017. Strategy performance represented by annual total returns for the following indexes: Market Capitalization (Market Cap) - S&P 500; Fundamental - Russell RAFI U.S. Large Company; Equal Weight - S&P 500 Equal Weighted; Momentum - MSCI USA Momentum; Low Volatility - S&P 500 Low Volatility; Quality - Russell 1000 Quality Factor. Indexes are unmanaged, do not incur fees or expenses, and cannot be invested in directly. Please see disclosures for more information about the market indexes. Past performance is not indicative of future results.
In 2017, momentum was again the top performer, and fundamental was a laggard, largely due to the impact of the FANG stocks. What will 2018 have in store for us? A reversal like we experienced in 2016, a continuation of 2017, or will another strategy be the top performer?
By no means is this an argument to ditch classic index strategy. Market-cap index ETFs are often low cost ways to invest in many slices of the market. And you may not want to sell investments in a classic ETF if it would trigger a tax bill. Rather, consider adding one or more smart beta strategies to your portfolio. As Tony notes: “The attractive risk-adjusted returns for smart beta can be valuable complements to traditional market-cap and actively managed strategies, to help create a diversified portfolio.”
What you can do next
Are you interested in adding a smart beta approach to your portfolio? You may want to start by exploring all your options.
- Talk to a Schwab Financial Consultant at your local branch about how smart beta can help you reach your investing goals.