Smart Beta

Understanding investment strategies - Smart beta / Factor investing

Historically investors have generally had a choice of two different investment fund styles to choose from, namely active and passive.

The former type of fund is overseen by a fund manager who analyses stocks and picks the securities, which they believe have the best investment potential.

Typically an active manager has a set universe of stocks to choose from, for example, a UK fund manager will perhaps pick securities listed on the FSTE All-Share, while a US portfolio manager will maybe look to the S&P 500. But whatever their investment arena, the primary goal of an active fund manager is to deliver returns greater than that of their market.

In contrast passive funds, which invariably carry lower annual charges than active portfolios because they have fewer overheads, are run by automated systems that simply mirror the performance of a particular index.

How smart beta/factor investing works

Passive portfolios are constructed using a market-capitalisation approach. This means they focus on company size and they will invest in shares in the same proportion as the market or index they are tracking. As a result the largest companies in the index being tracked, will inevitably be the portfolio’s biggest holdings.  

The main issue with this approach is that the largest companies will have the biggest impact on the fund’s overall performance, while smaller firms will have far less an influence. Smart beta funds take a rules, or factors, based approach which emphasizes other characteristics separate from market capitalisation in order to take advantage of market inefficiencies.

These factors are used to decide which securities to hold in a smart beta or factor investing fund - and how much of a portfolio should be dedicated to a particular security. There are plenty of different elements - or factors - which smart beta funds target but some of the most common include:

  • Equal weighting – a fund follows an index but equal weights its constituents
  • Low volatility – holdings are based on the volatility of  securities
  • Dividend income – a fund selects its constituents based on the strength of their dividend payments.
  • Fundamentals – a fund chooses its holdings based on factors such as cash-flow and earnings
  • Momentum – a portfolio will be inhabited fund with holdings based on their ability to leverage market trends

Active vs. passive

It has been long-debated which is the better investment style - are investors better off opting for a low-cost passive fund or does it make more sense to pay a larger fee to a fund manager in the hope of enjoying superior investment returns. 

Here smart beta – or factor investing funds – aim to bridge the gap. These portfolios, like passive funds are still index based and can come in the shape of mutual funds or exchange traded funds, more commonly referred to as ETFs.

These investment vehicles, which are also sometimes referred to as strategic beta funds look to offer investors the potential best of both worlds. 

In other words, smart beta funds are designed to deliver the fundamental research, analysis and flexibility which goes into active management - and therefore the potential for market beating returns - but with a lower yearly charge.

Advantages and disadvantages of smart beta

The primary advantage of smart beta or factor investing is that it offer investors the opportunity to enjoy potentially market beating returns for a lower cost than actively managed funds. In addition, smart beta funds can potentially provide investors with the long-term building blocks for a well-diversified portfolio. However while smart beta funds aim to deliver better than average returns to investors, there is no guarantee that they will - and they could underperform the wider market.

In addition, style issues may interfere with performance.  At any given time, a smart beta fund’s rules - or factors - for example, low volatility or momentum, may be in or out of favour with the market, which could reduce returns. But even if your manager’s investment style is in favour, they could still underperform.

The bottom line

Smart beta or factor investing  funds are essentially a combination of active and passive strategies. They aim to deliver the best of both worlds - the flexibility and potentially market beating returns of active portfolios – but for a price closer to that of a passive strategy.

Smart beta funds take a rules, or factors, based approach which emphasizes other characteristics separate from market capitalisation in a bid to take advantage of inefficiencies in the market. Some funds for example will focus on volatility, while others will target dividend yields. They can potentially provide investors with the building blocks for a well-diversified portfolio and while smart beta funds aim to deliver alpha to investors, it is important to bear in mind that such an outcome is not guaranteed. 


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