What is smart beta?• Definitions of smart beta vary depending on who is providing them but, in essence, it refers to investment strategies based on something other than the traditional market-capitalisation weighted indices. 
• You can use them to tap into growing dividends, to minimise volatility or ride market momentum; they can help you access more esoteric commodities. They are just some of the smart beta strategies which can be accessed through exchange-traded funds, index funds and segregated portfolios and which are attracting growing interest from investors.
• Products sit between the two poles of investment management. On one side are active funds where managers pursue their own strategy, regardless of the composition of the benchmark by which they are measured, with the aim of generating alpha – or a return above that generated by the market as a whole. On the other is a range of passive funds such as exchange-traded products (ETPs), which track an index, a sector, a geography or a particular market niche. By their nature, these will simply mirror the beta, or a return from the index they track, less management fees and other – usually minimal – aspects of tracking error.
• Smart beta takes an index and refines it with the aim of improving the risk-return outcomes. 
• The market is driven by the realisation that there are systemic drivers, or factors, behind market performance that can be isolated and tracked. These include size, volatility, momentum, value and quality. An investor looking to build a defensive portfolio, for example, could use a low volatility or quality smart beta fund; a more aggressive investor might look for momentum strategies.
• Such strategies have been available for decades through actively managed products; with smart beta, they are now available as low-cost, transparent, passive products too.

What types of smart beta strategies are there? Morningstar identifies three:
1. Return-oriented strategies, which aim to improve returns relative to a standard benchmark. These would include strategies like value, growth, momentum and yield.
2. Risk-oriented strategies, where the aim is to reduce or increase the risk of a standard benchmark, such as low volatility or risk-weighted funds.
3. A catch-all ‘other’, including funds that ignore the market-cap weighting commonly used for stock market indices like the FTSE 100 or the S&P 500, and instead invest equally in all the constituents as well as more esoteric commodity, property and debt strategies.

Impressive growth• Growth in the market has been impressive: BlackRock estimates that the cumulative flows into global equity smart beta ETPs over the last five years totalled $167bn, and the total assets in the category have grown to $248bn – reflecting an annual growth rate of over 45% during this period. 
• Most popular were dividend-based strategies, for example, funds that screen for consistent dividend increases or high dividend yields, as investors sought alternative sources of income while bond markets remained subdued.
• Minimum volatility funds, which aim to reduce the volatility of portfolios, are also popular, particularly in times of high market volatility.
• Smart beta funds originated in the US and that country still accounts for the lion’s share of assets under management: 57% of the total funds and 91% of the assets in this sector, as at 30 June 2014, according to statistics from Morningstar. Their popularity in the US is illustrated by the fact that smart beta now accounts for almost a fifth of the overall market for ETPs.
• Interest in Europe is growing rapidly: from nothing in 2005, they now account for $26.3bn of funds under management, according to Morningstar, having increased nine-fold in just five years. In 2013, they accounted for more than 30% of all inflows into ETPs. 
• While Scandinavia and the Netherlands were early smart beta adopters, UK pension funds and other institutions are increasingly investing in them, as are wealth managers for private portfolios, although direct retail investment is still relatively small.
• The smart beta concept has been around for decades. Its origins can be traced back to pioneering research by Eugene Fama and Ken French in the early 1990s, which found that factors like size and value, and later momentum (Carhart, 1997), explained excess returns over long time frames. 

Growing interest after financial crisis• The growing interest in smart beta as an investment tool has been spurred by the financial crisis, which has focused investors’ attention on the performance, costs and risks of fund management. Many supposedly active fund managers actually stick very closely to the benchmark, yet charge high fees for performance that can easily be accessed via a tracking ETP.
• Smart beta strategies go even further, by helping to isolate the factors that active managers use to generate their performance but at a much lower cost.
• While a smart beta fund is likely to have higher fees than standard weighted ETPs, they are still low compared with active products. Morningstar’s survey found that European smart beta products charged a weighted average of 0.36%, compared with 0.33% for those not using such techniques.
• There are factors which smart beta cannot take account of – such as the impact on energy companies of falling oil prices, government intervention or natural disasters. Many of these factors would, however, also be very difficult for active managers to predict.
• Just as active and passive strategies can play complementary roles in building a portfolio to suit individual circumstances, risk profiles and investment goals, so strategic beta will also be part of the passive armoury, helping to match performance to individual requirements. Selecting the right product will still require careful research and analysis of the benchmarks used and the factors and screening techniques used.
• Smart beta can be used in a variety of ways, including targeting exposure to specific factors, removing unintentional bias to particular factors or building portfolios with a range of risk and return profiles.
• Smart beta funds are also more transparent than active products, as investors can analyse the indices on which they are based.

Neither infallible nor risk-free• Of course, smart beta strategies are neither infallible nor risk-free. Ben Johnson, Director of Passive Manager Research for Morningstar, says: “Not all of these various strategies are smart and even the ones that are very smartly constructed are not going to necessarily feel all that smart over any given period. They are going to have their own unique performance patterns. They are going to underperform in certain market environments. They are going to lag the market in certain market environments.”
• There are factors which smart beta cannot take account of – such as the impact on energy companies of falling oil prices, government intervention or natural disasters. Many of these factors would, however, also be very difficult for active managers to predict.
• Just as active and passive strategies can play complementary roles in building a portfolio to suit individual circumstances, risk profiles and investment goals, so strategic beta will also be part of the passive armoury, helping to match performance to individual requirements. Selecting the right product will still require careful research and analysis of the benchmarks used and the factors and screening techniques used.

Smart beta can be used in a variety of ways, including targeting exposure to specific factors, removing unintentional bias to particular factors or building portfolios with a range of risk and return profiles.

Morningstar’s Johnson says that, while it is important to look at costs, it is also vital to consider who is behind the product. “Look for a capable, responsible sponsor, such as an asset manager that has indexing as a core competency and that has a wealth of experience when it comes to running index funds. This is particularly important in this context, given that the particulars of managing these indexes are a bit more complex relative to a broad market exposure. “It’s also important because a capable and responsible sponsor is going to emphasise launching investable strategies that have lasting investment merit and will likely do so at a low cost, as opposed to just chasing a fad and emphasising marketability over a strategy’s actual investment merit.”


The original version of this article was published in the June 2015 print edition of the Review.