Why 'smart beta' funds are taking off

Smart beta funds are becoming ever more popular with investors. Matthew Partridge explains how they work, and what to watch out for.

'Smart beta' funds are one of the fastest-growing parts of the investment industry. These funds aim to combine the benefits of both passive and active investing. Like passive funds, they set out to track an index as closely as possible, thereby bringing down costs.

However, they also try to provide better returns than the market by using indices that put a greater emphasis on certain types of stocks that have tended to outperform others.

There are three main approaches to building a smart beta fund. The first type changes the way that broad stockmarket indices are constructed. Instead of weighting each share by its market capitalisation, they instead weight by fundamental metrics, such as dividends, or simply give each share an equal weight. This implicitly pushes the fund toward cheaper shares.

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The problem is thatthese portfolios have regularly to be rebalanced to take account of changing market values and fundamentals.This increased trading pushes up transaction costs, eating into returns.

An alternative to this re-weighting of all the stocks in an index is just to hold those that meet specific criteria, such as the highest-yielding stocks. This is similar to the way that many active fund managers invest, but proponents of smart beta say that eliminating human discretion ensures that the fund will stick to its strategy.

One issue with this approach is that the resulting portfolio can be unbalanced: there is a tendency to end up with a large amount in certain sectors.

The newest version of smart beta involves the use of multiple criteria to screen and rank stocks. In theory, this should mean that these funds deliver a more balanced assessment of each stock and reduce the risk of temporary fluctuation in earnings, or special dividends, skewing the index.

However, their complexity makes it harder to see exactly what you are buying, and means that you have to trust in the fund's model. They also often come with higher fees comparable to traditional active funds.

If you want to learn more about smart beta, it may be useful to look at some smart beta exchange-traded funds (ETFs) and how their holdings and performance differ from the wider market.

For example, the db x-trackers S&P 500 Equal Weight ETF (LSE: XEQD) weights each S&P 500 stock equally. The iShares UK Dividend ETF (LSE: IUKD) tracks the 50 firms with the highest yield in the FTSE 350. And First Trust United Kingdom AlphaDEX UCITS ETF (LSE: FKU) ranks UK shares on both growth and value criteria. It has outperformed the FTSE 100 since it listed in April 2013.

Dr Matthew Partridge

Matthew graduated from the University of Durham in 2004; he then gained an MSc, followed by a PhD at the London School of Economics.

He has previously written for a wide range of publications, including the Guardian and the Economist, and also helped to run a newsletter on terrorism. He has spent time at Lehman Brothers, Citigroup and the consultancy Lombard Street Research.

Matthew is the author of Superinvestors: Lessons from the greatest investors in history, published by Harriman House, which has been translated into several languages. His second book, Investing Explained: The Accessible Guide to Building an Investment Portfolio, is published by Kogan Page.

As senior writer, he writes the shares and politics & economics pages, as well as weekly Blowing It and Great Frauds in History columns He also writes a fortnightly reviews page and trading tips, as well as regular cover stories and multi-page investment focus features.

Follow Matthew on Twitter: @DrMatthewPartri