Over the last few years, financial services providers have been falling over themselves to develop and bring to market new 'smart-beta' products. The value proposition for these investment vehicles is pretty straightforward: by offering rule-based and/or systematic security selection, smart-beta products can provide the benefits of active management but at a price much closer to that of passive index funds. Unfortunately, as investors move past this initial concept, they often encounter a confusing array of products and approaches. This disorder is not surprising when the dual origins of smart-beta are considered.
One set of smart-beta investments originated as 'fundamental' index funds - the logic and demand for which stemmed from the bursting of the technology stock bubble that occurred between 2000 and 2002. At the market peak in 2000, the technology sector accounted for almost 35% of the market capitalization of the S&P 500; two years later, after the bubble had burst, the sector accounted for about half as much. Looking back, academics and financial professionals reasoned that passive market capitalization weighted index funds had failed to protect investors because, as the price of technology stocks rose to extreme levels, passive index investors were taken along for the ride. If, instead of weightings based on market capitalization, funds weighted their holdings based on other measures of stocks' economic footprints (like revenue, dividends, or book value), investors would have more appropriate equity exposure that would be less susceptible to excesses of rampant speculation in any individual stock or industry. As this idea took hold, the financial services industry added not just fundamental index products, but also funds based on alternative weighting schemes that focused on top-down portfolio construction approaches like equal weighting, minimum volatility, and volatility management. These fundamental and alternative weighting investment vehicles represent one major piece of the smart-beta pie.
The second group of smart-beta products derived from quantitative, factor-based financial research. In the literature relating to equity market pricing, 'factors' are the sources of excess risk and return above and beyond the equity market risk factor. While there are hundreds of academic papers arguing for the existence of one factor or another, there are just a handful that have demonstrably and positively affected returns over a diverse set of time periods and geographies. These include value, momentum, low beta/low volatility, and profitability/quality. Factor returns are a function of being both long stocks that have positive factor exposure, as well as short stocks that have negative exposure to the factor. For instance, the value factor return is the return on stocks that are cheap minus the return on stocks that are expensive. The significant point here is that factor returns are market neutral, so while factor exposures can be accessed more completely by various alternative funds or strategies, most factor-based smart-beta products are only trying to participate in the 'long part' of the factor exposure. The various value, momentum, low beta, and quality factor investment vehicles try to provide long-only factor exposures by (most frequently) weighting the fund holdings based on the level of their exposure to that factor, or by screening out stocks that have negative exposure to that factor. Over the past few years, the industry has developed products that attempt to offer exposure to multiple factors within a single investment vehicle.
Taken together, fundamental index and factor-exposure products make up the vast majority of equity smart-beta offerings. The fact that both approaches often use the smart-beta label tends to add to investor confusion. Further complicating matters, many funds claim, to an extent, to be in both smart-beta camps -for example, a fundamental index based on book value will also naturally be exposed to the value factor. So, to determine whether the ultimate fund goal is to provide a fundamentally weighted index or to provide factor-based exposure, investors will oftentimes need to look deeper into the product's construction methodology. Product design differs greatly and will have a significant impact on the likelihood that the fund will be able to accomplish its objectives. Ultimately, this means that a smart-beta product should be evaluated based upon (1) whether it is a fundamental/alternative index or a factor-based fund, (2) consideration of the goal of the particular smart-beta strategy, and (3) whether the product design makes it likely that the fund will accomplish that goal.
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