Should you buy into ‘smart beta’?

Smart beta' has got big institutional investors buzzing. So what is it, and should you be getting excited too?

Beta' is the performance you get when you buy the whole market and alpha' is the value you can add (or subtract) by taking on bets against the market. You would buy beta through an index fund or exchange-traded fund (ETF) at a low cost, whereas alpha is what you pay an active fund manager rather more to try and achieve. Since it's very hard to find a fund manager who produces alpha consistently, many investors have switched to indexing.

However, there have been rumblings of dissatisfaction with conventional market indices and tracker funds. The usual way of measuring the market's return is via capitalisation-weighted benchmarks. This means that the stocks or bonds are weighted by their market value: the bigger the market footprint of the stock, the bigger the share of the index it takes up.

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The problem is that during bubble periods, indices' weightings in individual stocks and sectors can become distorted. For example, Japan's stockmarket took up nearly half of a global equity index in 1989, while technology and financial stocks received outsized weightings at the peak of their bubbles, in 2000 and 2008 respectively. In each case you'd have bought too much exposure to overvalued assets by buying into the index.

Smart beta' tries to solve this by tweaking the way the benchmark index is put together. You can now buy several types of index-tracking funds that follow these improved indices. Some follow equal-weighted indices these are rebalanced frequently to ensure that each constituent stock receives the same cash investment.

Low volatility' and minimum variance' portfolios focus on stocks that have proved least risky in the past. Fundamental' indices select constituents according to a variety of accounting metrics. High beta' funds choose economically more sensitive shares.

Not everyone agrees with this approach. Indexing giant Vanguard notes that some of these new index ideas are complex and based on unproved backtesting. You also pay a bit more for smart beta. For that reason I like a simple smart beta approach such as equal-weighting. Ossiam's Stoxx Europe 600 Equal Weight ETF (LSE: L6EW) applies the concept to a broad index of European stocks. The fund charges 0.35% a year and is worth a look.

Paul Amery edits www.indexuniverse.eu, the top source of news and analyses on Europe's ETF and index-fund market.