Have you heard of smart beta funds? If the money flowing into these investments is any indicator, then most likely you have heard of these funds. On the off-chance you haven’t heard of them, in this post I will walk you through what these fund offerings are and whether or not you should consider them part of your investment plan.
What Are Smart Beta Funds?
In a general sense, the term smart beta is just a term to get investors interested in these offerings. In fact, they were actually called fundamentally weighted index funds up until 2011. During their time (from 2004-2011) fundamentally weighted index funds weren’t very good for pulling in investor’s money. In fact, they averaged about $25 billion a year. In 2012 when the name changed to smart beta funds, $43 billion poured into these funds. Last year, $81 billion came in. So what are they exactly?
They are exchange traded funds that instead of tracking an index, like the S&P 500, they track other measures, like dividend yield, profits or valuations. An example would be an ETF that invests in high yielding dividend stocks. Another example would be an ETF that invest in companies that grow profits for at least 20% a year for the past 10 years.
Why they use the term beta, I have no clue. Beta refers to a stocks overall riskiness in relation to the market. The stock market has a beta of 1. Any stock that has a beta higher than 1 is considered more risky than the market as a whole and anything with a beta of less than 1 is considered less risky than the market. A utility stock tends to have a beta of under 1 while a tech company will have a beta higher than 1.
You can also expect larger price swings (more volatility) from higher beta stocks and less (or smaller) price swings in lower beta stocks.
Should You Consider Smart Beta Investments?
If you ask a true passive index investor, the answer is no. These investments are not passive at all, in fact many argue that they are simply actively managed investments that are trying to appear as passive investments.
The good news is that regardless if you consider them to be active or passive, they tend to have much lower management fees than that of your typical active investments. This is because their structure limits what they can invest in. Looking back at the example of companies that are growing profit at 20% annually for the last 10 years is going to limit what the fund can invest in. As such, costs will naturally be contained.
I could see reasons why investors would want to invest in these funds, mainly those that are tracking high dividend paying stocks. But overall, these investments should not make up the majority of your investments. Keeping them to a small portion will allow you to take advantage of investing in smaller slices of the market but will also allow you to have a fully diversified portfolio.
[Photo Credit: khrawlings]