As a new generation of smart-beta index-based ETFs become more widely known, investors are beginning to try and grasp the idea about trading in an alternative index that does not follow the traditional market-capitalization weighted methodology.
However, many are wondering what “smart-beta” really means.
“Smart beta is simply about trying to identify good investment ideas that can be structured better… smart beta strategies should be simple, low cost, transparent and systematic,” according to Towers Watson, a leading global investment consulting firm that first coined the smart beta expression.
However, many alternative beta strategies fall short of this definition, according to Research Affiliates, the company behind the line of RAFI fundamental indices. Specifically, the research firm argues that some are overly complex or opaque in their value added, others incur unnecessary costs and there are those that don’t meet up to the smart-beta standards at all.
“The absence of a rigorous, generally accepted definition gives me-too firms enough latitude to stamp smart beta on anything that’s not cap-weighted indexing,” Research Affiliates said.
The company also vehemently contends that smart-beta strategies should be valuation-indifferent. Indices that include some form of market capitalization may miss out on potential returns due to the same return drag that affects other cap-weighted strategies.
Specifically, smart-beta strategies should be defined as “a category of valuation-indifferent strategies that consciously and deliberately break the link between the price of an asset and its weight in the portfolio, seeking to earn excess returns over the cap-weighted benchmark by no longer weighting assets proportional to their popularity, while retaining most of the positive attributes of passive indexing,” according to Research Affiliates.
Moreover, the firm argues that smart-beta methodologies should be passive in nature and follow most if not all of the following five factors: 1) Smart beta strategies are transparent. 2) Smart beta strategies are rules-based. 3) Smart beta strategies are low cost relative to active management. 4) Smart beta strategies have large capacity and the liquidity to accommodate easy entrance and exit. 5) Smart beta strategies are well-diversified and/or span the macro economy.
For more information smart-beta funds, visit our indexing category.
Max Chen contributed to this article.