What are smart beta funds?

What you’ll learn:

• What the difference is between active and passive investing.
• How smart beta offers an alternative approach.
• What the different styles of smart beta are.

One of the fundamental aims of smart beta is to bridge the gap between traditional active and passive investing. The sector is widely considered to be one of the fastest growing segments of the investment universe. Worldwide the value of smart beta funds stood at $880 bn (£683bn) in 2019, up from $616 (£478bn) in 2016¹.

The active versus passive debate

Passive funds, sometimes referred to as index or tracker funds, are usually run by automated trading systems. They simply aim to mirror the make-up and trajectory of a particular market or index, such as the FTSE 100.

Exchange traded funds, (ETFs) are another type of passive investment. However, unlike index and tracker funds, which are priced once a day, ETFs are traded on the stock exchange and can therefore be traded in ‘real time’ like shares. With all passive portfolios, if the market being tracked rises, so does the fund’s value, and vice versa and because they are computer run, they can charge some of the lowest management fees around.

Find out more about the cost of investing in funds

In contrast, when you invest in an actively managed fund, you are effectively investing in a fund manager’s ability. A manager will decide which stocks to hold and which to sell and their primary goal is to outperform the market in which they invest. But for this service, they typically levy significantly higher annual charges than their passive counterparts.

Advocates of passive investing argue that active managers often fail to outperform on a regular year-in, year-out basis and that the lower costs of passive funds can lead to potentially better long-term returns. But on the flip side, those who prefer the active route often claim that despite the lower associated costs passive strategies cannot protect investors during a downturn.

Find out more about active and passive investing

The rise of smart beta

Over recent years, and especially since the global financial crisis, investors have witnessed a rise in so-called smart or strategic beta funds within the ETF market. The aim of these vehicles is to deliver the sorts of returns an active fund might achieve but for a slightly higher cost than a passive investment. They are usually considerably cheaper to own than traditional actively managed funds.

Passive funds typically use a market-capitalisation approach when it comes to the investments they hold - in other words, they focus on company size. This means a normal passive fund will invest in shares in the same proportions as the index they are tracking, so an index’s largest constituents will be the biggest holdings in the fund. Proponents of smart-beta highlight however that by using this methodology, the firms with the largest market size within a “market cap” weighted index will generally have the greatest impact on performance as well as volatility. In contrast, the smaller constituents will have far less influence.

The aim of smart-beta is to buck this trend by deviating from the traditional market-cap approach. Instead smart beta is about constructing a rules-based passive portfolio, which doesn’t use market-cap to select and weight holdings.

The basic thinking behind smart beta is that markets are not always efficient, so as a result, share prices don’t always give an accurate impression of a company’s potential. Smart beta funds aim to leverage such anomalies in a bid to achieve market-beating returns, which historically has been the preserve of active managers. Of course, there are no guarantees that they will do this, and there is always the risk that you could get back less than you put in.

Smart beta styles

Smart beta funds come in a wide variety of styles. Rather than using traditional market capitalisation based indices as ordinary tracker funds do, smart beta uses a range of different strategies which aim to add value by choosing, weighting and rebalancing holdings based on other factors.

Some funds for example, adopt a ‘fundamental weighting’ approach. Essentially this means managers create or follow an index which weights investments according to their fundamentals, for example, their cash flow, earnings, book value, dividend income or even dividend growth, rather than their market capitalisation.

Some smart beta styles alternatively will opt for an ‘equal weighting’ approach, meaning that each holding is given the same showing, irrespective of their actual market size. Others will follow an index made up of companies that in aggregate have a potentially lower level of volatility relative to the broader market.

As an asset class, smart beta is not limited to equities. Fixed income smart beta ETFs, which invest in bonds are on the rise too.

Always remember, that value of investments can fall as well as rise and you could get back less than you invest. If you’re not sure about investing, seek independent advice.