And this tells you everything you need to know about how anxious investors have felt this year.
“Smart beta” is more or less an investing strategy that calls for investing in indexes that are weighted differently than the traditional market cap method.
For example, an investor looking to replicate the returns of the S&P 500 — which many investors are — can buy an “index fund” which is simply an exchange-traded fund or mutual fund that seeks to replicate the S&P 500’s performance. These instruments will have a beta of 1, meaning this asset’s volatility will be the same as the market’s.
Assets with a beta above 1 are more volatile than the market, though the idea is that these assets will outperform. (Netflix, for example, is a high beta stock.) Low beta stocks will be less than volatile than the market but produce steadier — though potentially lagging — returns. (Think Coca-Cola.)
But since the S&P 500 is constructed by taking all the index’s components and then giving these components weights based on their market cap, or simply how large the company is, this investor will also own more than Apple than anything else. And the reason this will be the case is simply because Apple is the biggest company in the index.
Enter “smart beta.”
As Investopedia writes, smart beta is a “new, popular financial product that attempts to beat indexed funds, but many investors are still not familiar with it.”
Broadly, smart beta is a type of what you would call “factor-based investing” which weights indexes of stocks based on certain performance or financial measures other than simply the size of the company.
A smart beta strategy, for example, may involve buying a basket of 30 S&P 500 stocks weighted based on how much free cash flow these companies throw off each year. Smart beta strategies are also rule-based and designed to be transparent, meaning investors are supposed to know exactly what will happen with their basketed investment if certain other things happen.
In short, no major surprises.
Back in September 2014, hedge fund manager Cliff Asness wrote a paper titled, “Smart Beta: Not New, Not Beta, Still Awesome.” And as Asness wrote in his paper, co-authored with his colleague John Liew, smart beta is mostly, “re-packaged, re-branded quantitative management.”
Asness added, “That’s not to say we don’t like [smart beta] or think it’s not good for investors. We love quantitative management, having spent our careers pursuing these types of strategies. However, we work in a business where good ideas are constantly repackaged as something new. Smart Beta is the latest example.”
Smart beta, as Asness writes, is still an active strategy because by choosing a smart beta strategy an investor is making an effort to not merely match but
outperform the market. And so while the strategy itself may be transparent, choosing the strategy is an active decision and inherently
not giving investors beta (which, again, is a proxy for market-level volatility and returns).
What investors buying smart beta strategies want, in other words, is alpha.
And whereas buying Vanguard’s S&P 500 index fund is “passive” because the index itself will not be managed in any way that isn’t an effort to replicate the actual S&P 500’s weighting and return, smart beta involves investors making a bet on how they can be rewarded with above-market returns. Additionally, investors are deciding what factors to overweight and making a judgment on which factors they think will offer the most attractive return.
On some level, of course, buying stocks via an S&P 500 fund is a broad bet that the economy will either improve or remain steady, thereby allowing corporate profitability to increase over time. But no investing comes without risk, and for someone who wants to “own stocks” the S&P 500 is your standard plain vanilla investment.
And so back to why an increasing focus on smart beta makes total sense in 2015.
All year, strategists and other commentators have noted that something in the markets seemed “broken.”
There have been seemingly never-ending concerns about bond-market liquidity. And in the wake of the August 24 “flash crash” seen in the stock market, concerns about whether exchange-traded funds will “work” — meaning: will these funds will give investors accurate proportional claims on the assets underlying the fund — in times of stress have also weighed on markets.
And of course, returns have been sort of crappy, which is going to make investors re-examine their strategies and assumptions.
Investors have short memories, and while the S&P 500 has more than tripled since the 2009 low seen after the financial crisis — in addition to the index gaining more than 10% in each of the last three years — the last 11 months of an essentially flat stock market has taken its toll.
As a result, investors want something different.
Maybe something smarter.
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