This article was written by Invesco PowerShares Vice President, ETF Product Management, John Feyerer.

While the incessant buzz around smart beta index strategies continues unabated, much of the discussion seems to center on either the terminology or the different weighting methodologies —fundamentals, dividends, equal-weighting and more. But what’s not often talked about is the importance of a simple, objective, rules-based rebalancing discipline.

Why is rebalancing so critical?

     A regular, rules-based rebalancing mechanism creates the opportunity for a smart beta index strategy to contra-trade against recent price movements — in other words, trimming weight in stocks that have recently risen in value and adding to those that may have underperformed. This is the opposite of what we see with market-capitalization-weighted indexes, which — thanks to their use of current share price to determine constituent weight — may become overexposed to stocks that have recently increased in value and underexposed to those that have recently fallen in value. This flies in the face of the investor objective of buying low and selling high instead buying high and selling low.

     The various factors that smart beta indexes are designed to identify and weight — such as value and low volatility characteristics — may rotate between companies or sectors. Rebalancing allows these shifts to be reflected in the indexes’ allocations.

     Many investors tend to chase returns — adding money to strategies and stocks that have recently outperformed while subtracting from those that have underperformed. At the simplest and most basic level, smart beta index strategies that are systematically rebalanced remove the emotion from the decision-making process.

Rebalancing in action

On the third Friday of each March, the FTSE RAFI Fundamental indexes — which are smart beta indexes — undergo their annual rebalance. The holdings of each index are reconstituted based upon four fundamental measures of company size: sales, cash flow, dividends and book value. This results in the indexes’ constituent weight being adjusted across securities, sectors and countries without any contemplation of share price, recent performance or the latest market sentiment.

Let’s take the FTSE RAFI US 1000 Index as an example. During its March 2015 rebalance, the largest adjustment was a nearly 2% increase to the energy sector,1 which illustrates how a disciplined rebalancing process can push investors out of their habit of chasing returns. From July 1, 2014, through March 31, 2015, the energy sector declined 20.8% in value and underperformed the broader S&P 500 Index by -27.2%,1 largely driven by the precipitous drop in the price of oil. Many investors would pause before increasing their allocation to such an embattled sector, but smart beta index strategies are indifferent to market sentiment — they simply rebalance their holdings based upon a pre-determined schedule. Changes are determined 100% by rules and 0% by emotion.

While the price of oil and the energy sector may have further to fall, the discipline of the FTSE RAFI rebalancing process is positioning the index to benefit from potential mean reversion in this sector. By comparison, the capitalization-weighted Russell 1000 Index has seen its weight in energy drop from 10.1% to below 7.6% since July 20141 and, without an inherent rebalancing mechanism, wouldn’t benefit as much from an eventual mean reversion as strategies that employ such a discipline.

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