Advertisement

Smart beta

Smart beta funds aim to combine the best aspects of passive and active management, aiming to beat the index by eliminating any element of discretionary human judgement.

Smart beta funds aim to combine the best aspects of passive and active management. Like active funds, they aim to beat the index. However, they do this by eliminating any element of discretionary human judgement.

Instead, a smart beta fund uses a mechanical set of rules to choose stocks that are expected to outperform the index. By avoiding using an expensive human manager, smart funds cut costs, and reduce the risk that the fund will shift its style over time.

Advertisement - Article continues below

The simplest smart beta funds build bespoke stock indices, by re-weighting existing indices using their own criteria. For example, some funds weight each individual share in the S&P 500 or FTSE 100 equally (rather than by size). A similar strategy is to use earnings or dividends to weight the portfolio. This approach implicitly aims to boost the proportion of cheap and smaller companies in the index relative to traditional indices, which are dominated by large firms.

A more "active" version of this strategy is to cut out expensive shares altogether, by only picking stocks that meet certain criteria, such as those with low price/earnings ratios or above-average dividend yields. Some of the most elaborate smart beta funds run complicated screens, using a variety of criteria, to rank shares. The idea is to ensure that the selection isn't skewed by one single metric.

Critics argue that all three types of smart beta funds have big potential downsides. Equal-weighted indices need to be rebalanced frequently, which raises costs. Funds focusing on one criterion run the risk of becoming overly concentrated in one particular sector. And those that use multiple criteria are frequently just as expensive as active funds, and often even less transparent. The key as with any fund is to understand what you're buying.

Advertisement
Advertisement

Recommended

Visit/glossary/bonds
Glossary

Bonds

A bond is a type of IOU issued by a government, local authority or company to raise money.
19 May 2020
Visit/spending-it/glossary/601300/quantitative-investing
Glossary

Quantitative investing

Quantitative investing uses sophisticated computer-based mathematical models to identify and carry out trades.
8 May 2020
Visit/glossary/quantitative-easing-qe
Glossary

Quantitative easing (QE)

Quantitative easing (QE) involves electronically expanding a central bank's balance sheet.
8 May 2020
Visit/glossary/600702/emerging-markets
Glossary

Emerging markets

An emerging market is an economy that is becoming wealthier and more advanced, but is not yet classed as "developed".
24 Jan 2020

Most Popular

Visit/investments/commodities/industrial-metals/601401/money-printing-infrastructure-base-metals-copper
Industrial metals

Governments’ money-printing mania bodes well for base metals

Money is being printed like there is no tomorrow. Much of it will be used to pay for infrastructure projects – and that will be good for metals, says …
27 May 2020
Visit/economy/eu-economy/601422/heres-why-investors-should-care-about-the-eus-plan-to-tackle-covid-19
EU Economy

Here’s why investors should care about the EU’s plan to tackle Covid-19

The EU's €750bn rescue package makes a break-up of the eurozone much less likely. John Stepek explains why the scheme is such a big deal, and what it …
28 May 2020
Visit/investments/funds/601385/in-support-of-active-fund-management
Funds

In support of active fund management

We’re fans of passive investing here at MoneyWeek. But active fund management has its place too, says Merryn Somerset Webb.
25 May 2020