Black Friday might be behind us, but I’m still hunting for bargains this holiday season. This year I’m determined to be tempted only by the sales on the things I actually want and need. Too often I’m tempted by a bargain that turns out to be, well, a dud.
The challenge for investors is much the same. We’ve all become more fee conscious in recent years, and are often seeking more for less, but just may end up getting… less. If you think there’s got to be a better way, you’re right.
I’m talking about smart beta, which can offer a similar risk and return profile to certain traditional active strategies at a lower cost. As I discussed in my last post, smart beta strategies seek to enhance risk-adjusted returns through exposures to desirable factors or themes – much as traditional active strategies do — but delivered in a transparent and rules-based way, like passive strategies.
So where might this “hybrid” class of investments fit into your portfolio? Let’s take a peek under the hood of smart beta to find out.
Where returns come from
You can think of the return of any portfolio as the result of its many exposures. Many investors compare the total return of a fund to a relevant market benchmark. This comparison helps us determine if the manager is faring well or poorly compared to the relevant opportunity set. Any return above that benchmark return is “active” – the value added by the investment manager, beyond exposure to the broad market. A portion of that active return may be the result of the manager’s skill: their unique insights in security selection, country bets or market timing. And a portion of that “active” return can be attributed to the fund’s exposure to style factors, like value or momentum – the very same style factors that can be captured in smart beta strategies.