What is a Smart Beta ETF?
A Smart Beta ETF aims to deliver the best of both worlds – to beat the market or to match it while taking less risk – precisely what an active investing product would hope to do, yet they follow an index and deliver the advantages of passive investing.
Smart Beta ETFs exploit investing anomalies that are known to have beaten the market over the long term – finding companies that are undervalued, highly profitable or with a long track record of outperformance and creating an index that filters out those that do not fulfil those criteria.
By contrast, a Smart Beta index that tracks, for example, undervalued companies will apply a formula to the market index in order to up weight stocks that look cheap and down weight those that seem expensive; it aims to beat the market by holding more of the types of securities that have historically outperformed and tend to be more expensive than passive trackers.
In the same way that equities beat cash and bonds over time because investors expect to be rewarded for investing in riskier assets, academics have discovered securities which outperform their peers because they are more risky or because they somehow confound human behaviour, causing them to be undervalued.
Specially developed formulae identify these special security categories which are known as investing styles or factors and underpin Smart Beta ETFs.
Five factors that have outperformed the market historically are:
- Value – unglamorous firms, with volatile dividends and high earnings risk are often underrated by investors; a value firm’s comparative cheapness can be a source of strong future returns.
- Small cap – smaller companies are riskier than large cap ones because they’re more vulnerable to misfortune; investors expect a greater investment return in exchange for taking on greater risk.
- Quality – companies that make efficient use of their capital tend to outperform over time when, for example R&D pays off; investors often underrate quality firms because their spending can make them look like they’re underperforming now.
- Momentum – rising stocks tend to keep rising for a limited period, while losing stocks continue to fall as investors over-react and under-react to news.
- Low volatility – large, non-cyclical companies such as utilities that deliver market-like returns but for significantly less risk and show resilience during recessions.
By taking on these risks, investors expect to be rewarded with greater returns when economic conditions and sentiment cause individual factors to bounce back.
Value, Momentum and Small Cap have done well in times of economic growth and rising inflation and interest rates, whereas Quality and Low Volatility have been defensive and delivered outperformance in downturns.
New investors should understand that the Smart Beta promise of market-beating returns will not necessarily come true and you may have to endure years of underperformance before your investment pays off.
However, the main factors listed above have been shown to work across multiple countries, asset classes and decades which is why Smart Beta has become so popular.
Better still, some of the factors have low correlations with one another, so the underperformance of one can often be offset by the outperformance of another.
For example, value is known to have low and even negative correlations with profitability and momentum.
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