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.
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.