In the fund space, smart-beta exchange traded funds have experienced a growth spurt and are attracting greater interest. Nevertheless, many are still not quite sure what smart beta entails.
“We think smart-beta strategies could be described as an effort to seek outperformance of a market index at low total cost (as measured by factors such as expense ratios) and with the features which have made ETFs popular, such as transparency into portfolio holdings or relative tax efficiency,” according to Goldman Sachs Asset Management.
Smart beta covers all rules-based ETF investment strategies that try to outperform a traditional market capitalization-weighted index or help diminish risk versus a traditional benchmark.
“If this explanation sounds technical, that’s because it is – and therein lies the challenge,” according to Goldman “In our view, investors need more than ‘technical’ explanations when considering new investment ideas.”
Many investors remain unfamiliar with the smart-beta term. According to Goldman Sachs, only a handful of investors have heard of smart beta investment strategies, and even those familiar with the term could not accurately explain them. Additionally, affluent investors were also unfamiliar with smart beta ETFs. Consequently, Goldman sees that investors and investment professionals are essentially a “blank slate” when it comes to smart beta. [What Holds Investors Back From ETF Exposure?]
Goldman points out that discussing smart beta as a blend of active and passive may cause greater misunderstandings as many have different interpretations of what is active and passive. For instance, some reveal that “active” means the investor carries out an investment decision, whereas “passive” means someone else manages an account. In contrast, investment professionals and industry insiders define “active” as a fund based off active portfolio management and “passive” as something that passively tracks an index.
“In our view, describing smart beta as a ‘blend’ of active and passive investing can be confusing, and thus ineffective, in explaining its potential benefits, risks, and rewards,” according to Goldman.
Instead, people may be better served through defining smart beta by what it is not. Specifically, smart beta does not follow a traditional market-weight index – an index that weights components based on the size of the company, so larger companies have larger weights. Instead, smart beta may weight components based on a given investment goal, such as low-volatility, so the stocks that exhibit the least volatility have the largest weight in the underlying index.
The rise of smart-beta indices comes as more see a flawed approach in a market capitalization-weighted index, which provides the largest weight to the biggest companies, since investors will be exposed to overpriced stocks. However, Goldman pointed out that the majority of investors still have a favorable opinion of traditional cap-weighted ETFs and lack familiarity with financial terms that describe smart beta strategies.
“We believe approaches which seek to critique traditional market-weight index ETFs make it more difficult to understand these strategies for what they can offer a portfolio,” according to Goldman.
Consequently, investors who want to better understand smart beta should understand the similarities and slight differences with traditional market-weight indexing. Additionally, investors should be aware the risks and potential rewards of smart beta strategies in their effort to outperform traditional indices.
For more information on rules-based investment strategies, visit our smart beta category.
Max Chen contributed to this article.