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The Smart Way to Approach Smart Beta

Smart Beta Strategies: Understanding Key Differences

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-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 1,000 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 2006 through September 2016, comparing the yearly performance of each to the performance of a classic market-cap-weighted index.

As you can probably guess, there is no single strategy that shines year in and year out. During the bear market of 2008, the best performer was the low-volatility strategy, and the laggard was the fundamental strategy. But as the bull market began in 2009, the low-volatility strategy took last place, and fundamental outperformed every strategy except equal-weight (which was itself second to last the year before).

“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.

The Smart Way to Approach Smart Beta

While most smart beta strategies claim they outperform their market-cap equivalents, the return patterns clearly vary.

By no means is this an argument to ditch classic index strategy. Market-cap index ETFs are often the cheapest way 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.

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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.

Past performance is no guarantee of future results.

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

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

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

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 FTSE RAFI U.S. 1000 Index was launched in association with Research Affiliates®, LLC. As part of FTSE Group’s range of alternative-weighted indexes, the FTSE RAFI Index Series selects and weights index constituents using four fundamental factors, rather than market capitalization. The factors are dividends, cash flows, sales and book value. The FTSE RAFI U.S. 1000 Index comprises the 1,000 U.S.-listed companies with the largest RAFI fundamental scores selected from the constituents of the FTSE USA All Cap Index, part of the FTSE Global Equity Index Series. The index is reconstituted annually. Influence: Rob Arnott and Research Affiliates.

The S&P 500® Equal Weight Index is an index developed by Standard & Poor’s in collaboration with Guggenheim Investments. Each of the stocks that make up the index is “equally weighted.” To maintain composition, the S&P 500 Equal Weight Index rebalances quarterly.

The Russell 1000 Momentum Factor Index is an index derived from the Russell 1000 Index, designed to capture the Momentum Factor—momentum is described as securities tending to continue to do what they are already doing (either rising or falling in price).

The Russell 1000 Low Volatility Index is an index derived from the Russell 1000 Index, designed to capture the Volatility Factor—volatility is described as a measure of a security’s variability in total returns based on its historic behavior. A low-volatility index is considered to have a lower return variability than the overall market.

The S&P 500® High Quality Index is designed to track high-quality stocks in the S&P 500 by quality score, which is calculated based on return on equity, accruals ratio and financial leverage ratio.

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


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