Note: This article is courtesy of Iris.xyz

By Paul L. Keeton, Vice President at Dorsey, Wright & Associates (A Nasdaq Company)

In case you missed it, along with just about every kid finishing third grade this year, Smart Beta ETFs have now been around for about a decade. Yet despite their relative maturity, many advisors continue to find it challenging to explain Smart Beta to their clients. No matter how logical it may seem to those of us who live and breathe investing, it can sound like a complicated blur of numbers, figures, and magical formulas to an investor who is seeking a higher level of performance but knows little about market dynamics or the technical strategies behind Smart Beta ETFs.

The solution? The next time you sit down to talk about Smart Beta to a client, consider taking this simple approach we’ve used to educate third graders on the topic:

Step #1: Introduce how supply and demand affects price

Tear open a large bag of M&Ms in a third-grade classroom, and you have everyone’s attention. (The same is probably true when you sit down with a client, even though you’re just talking through the idea.) In the classroom, if we divide 125 M&Ms equally among the class so each child has 5 M&Ms, everyone is equally happy. If we ask who wants to trade their M&Ms, no hands go up. But if we introduce new information, the game changes. Tell a class of third graders that blue M&Ms are guaranteed to make them run faster, and suddenly there’s a run on the market. When the kids are asked to trade candy this time, what happens? Suddenly the balance between supply and demand has changed. Everyone wants blue M&Ms and for this reason they now have greater market value than before. What changed that value? In this case, it was the introduction of new information. And, of course, as demand increases, so does price. One blue M&M may now fetch the price of two or three M&Ms of another color.

Since the average mix of M&Ms includes only a 10% allocation to blue M&Ms, they’re already a bit scarce. If we then ask everyone who has one of the blue M&Ms to eat one, we’ve decreased the supply of blue M&M’s from 12 down to just six. Supply has now decreased significantly, demand has likely remained at least constant, and the price of blue M&Ms has thus increased yet again.

The exact same behavior is true of stocks. When demand outpaces supply, and there are more willing to buy than able to sell at a current price, price must rise.

Click here to read the final two steps on Iris.xyz.

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