“Smart beta,” or strategic beta, is an investment product
designed to track particular stocks or assets in an index rather than the
entire market like a passive or beta fund, and it is one of the fastest growing
in recent years as it has often delivered market-beating returns.
Assets held in such investments have increased four-fold in
the U.S. over the last five years to a total of around $315 billion, according
to Morningstar, and have continued to grow by about 4.1% so far this year.
Of course, while passive tracker and exchange-traded beta
funds are growing much slower, the total assets they represent are much greater
overall at around $3.6 trillion in the U.S. However, smart beta funds do not
appear to be a fad, as they have certain characteristics that will likely continue
to make them attractive to some investors.
The idea behind them is to pick out parts of the market that
outperform, such as small company stocks or undervalued stocks – hence the “smart”
moniker. If this sounds a bit like active management, that’s because, to some
extent, it is. Indeed, active management groups have been the leaders in
developing such products, as they began finding it more difficult to produce market-beating
returns otherwise. In their view, such a strategy can combine some of the risk-mitigation
benefits of passive investment strategies with the higher upside potential of
active selection.
So far, such a strategy has proven attractive to many
investors, including private banks, high net-worth individuals, and very large
institutions such as the Government Pension Investment Fund of Japan. Still,
even a mix of passive and active strategies involves a risk that is
qualitatively different than one that is purely passive, and one of the biggest
risks of active strategies is not that they will lose their value (which can
happen with passive investments as well), but (much more likely), that they
will fail to beat the portfolio comprised of purely passive investments
tracking the same indices.
This has led some critics to the conclusion that investors
are better off picking one or the other – passive or active management. To the
extent “smart” beta entails higher fees than passive funds (most often the
case), this argument would seem to become more salient – i.e. if you are paying
your fund manager to select assets, why pay for them to choose passive
investments? And, conversely, if you want to invest in a passive, market tracking
strategy, why pay higher fees to implement that strategy?
However, others argue that smart beta is still just that – i.e.
a beta product – only it offers the chance to zero in on the “best parts” of
the market. While some may regard this as a bit of creative semantics, such
products do appear as at least something of a hybrid versus a traditional
actively managed fund. As such, while smart beta products may not be optimal for
all investors, they may offer an attractive mix of upside and consistency for
some others, which in turn helps to explain their dramatic recent and
continuing growth.