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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-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.
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Important disclosures:

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.

Russell Investments and Research Affiliates LLC have entered into a strategic alliance with respect to the Russell RAFI Indexes. Subject to Research Affiliates’ intellectual property rights in certain content, Russell Investments is the owner of all copyrights related to the Russell RAFI Indexes. Russell Investments and Research Affiliates jointly own all trademark and service mark rights in and to the Russell RAFI Indexes. Charles Schwab & Co., Inc. is not affiliated with Russell Investments or Research Affiliates. Effective December 1, 2016, the names of the Russell Fundamental Index Series and all associated indexes were changed from “Russell Fundamental” to “Russell RAFI” by the index provider. No other changes have occurred.

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 Russell RAFI TM 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. The Russell 3000® Index measures the performance of the largest 3,000 U.S. companies representing approximately 98% of the investable U.S. equity market.

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 MSCI USA Momentum Index is based on MSCI USA Index, its parent index, which captures large and mid cap stocks of the U.S. market. It is designed to reflect the performance of an equity momentum strategy by emphasizing stocks with high price momentum, while maintaining reasonably high trading liquidity, investment capacity and moderate index turnover.

The S&P 500® Low Volatility Index measures performance of the 100 least volatile stocks in the S&P 500. The index benchmarks low volatility or low variance strategies for the U.S. stock market. Constituents are weighted relative to the inverse of their corresponding volatility, with the least volatile stocks receiving the highest weights.

The Russell 1000 Quality Factor Index is an index derived from the Russell 1000 Index, designed to capture the Quality Factor - Quality is defined as securities tend to continue to do what they are already doing (either rising or falling in price).

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