THE RATIONAL INVESTOR: Why all the fuss about 'smart beta' funds?

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Investors are always looking for ways to generate excess returns, often designated by alpha, while only taking risk in line with the overall stock market, often designated by beta.

Recall, the beta of a portfolio is a measure of how volatile it is when compared to some index like the S&P 500 that is defined to have a beta of 1. They also want this at a cost in line with investing in traditional passive index funds. Out of this desire has evolved passive “smart beta” strategies.

Traditionally, most indexes tracked by passive index mutual funds were capitalization weighted. This means the amount of each stock in the index is proportional to its “market capitalization” – that is, the number of shares outstanding multiplied by its market price. Smart beta strategies attempt to take advantage of historical inefficiencies in capitalization weighting.

Load Error

Smart beta funds claim they can outperform traditional index funds when considering risk. The reason this outperformance is called smart beta rather than the previously mentioned alpha, is alpha is normally associated with a manager’s skill. Since these are passive, there is no manager’s skill involved.

This claimed outperformance is explained by SBF being designed to take advantage of one of three: increased exposure to market segments like value stocks and smaller capitalization stocks that have historically been correlated with outperformance; improved diversification that avoids stocks that haven’t provided returns in line with their risk; explicitly targeting stocks that have specified risk attributes.

Generally, SBF fall into one of four classes that in some fashion take advantage of the preceding three things:

• Equally weighted indexes; that is, all stocks have equivalent importance.

• Economic “footprint” weighted indexes; that is, each stock is weighted based on one or more economic factors like dividends, sales, or earnings.

• Risk weighted indexes; that is, each stock is weighted inversely to some measure of its risk like volatility or beta.

• Stock measure weighted indexes; that is, each stock is weighted respectively to some measure of a stock, like its book to market value.

There is growing evidence that smart beta funds don’t always provide the benefits their sponsors claim. “SBF do not offer a risk-adjusted performance superior to active and passive strategies,” École Supérieure des Sciences Economiques et Commerciales finance professors François Longin and Makram Belallah and business school student Youssef Louraui said in a recent paper.

Unfortunately, SBF often have higher turnover than capitalization-weighted funds as they must rebalance more often to maintain their strategies’ weights. This increases costs and may generate increased capital gains taxes.

Investors should understand that the outperformance of some of the factors that SBF are based on can require prolonged periods of time to become evident. Investors should also understand that there can be a trade-off between outperformance and increased volatility for some strategies.

One of the key risks that investors in SBF need to consider is the investor’s ability to handle “tracking error” risk. This means the returns of their fund may at times significantly underperform the returns of the capitalization-weighted fund.

All data and forecasts are for illustrative purposes only and not an inducement to buy or sell any security. Past performance is not indicative of future results. If you have a financial issue that you would like to see discussed in this column or have other comments or questions, Robert Stepleman can be reached c/o Dow Wealth Management, 8205 Nature’s Way, Lakewood Ranch, FL 34202 or at rsstepl@tampabay.rr.com. He offers advisory services through Bolton Global Asset Management, an SEC-registered investment adviser and is associated Dow Wealth Management, LLC.

This article originally appeared on Sarasota Herald-Tribune: THE RATIONAL INVESTOR: Why all the fuss about ‘smart beta’ funds?

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