There has been significant growth in the number of financial products, primarily exchange-traded products (ETPs), that are linked to, and seek to track, the performance of alternatively weighted indexes. These indexes are commonly referred to as "smart beta" indexes.
Benchmark vs. Smart Beta Indexes
Many investors are familiar with index funds, which are mutual funds and ETPs that seek to track the performance of a particular benchmark index. A few of the oldest and best-known indexes that these funds track, such as the Dow Jones Industrial Average, are price-weighted. In other words, the higher the stock price of Company X, the more weight Company X has in determining the value of the index.
Most other widely known benchmark indexes, including the S&P 500, NASDAQ 100 and Russell 2000, use a company's market capitalization to determine how much weight that particular stock will have in the index. A company’s market cap is its share price multiplied by the number of shares outstanding. These indexes are often referred to as market-weighted indexes.
Smart beta indexes take a different approach. Some give equal weighting to each of the stocks in the index. This typically results in smaller-cap companies being overweighted and larger-cap companies being underweighted relative to a market cap-weighted index.
Other smart beta indexes are based on more complex methodologies. For example, there are products linked to fundamentally weighted indexes in which the index components are determined based on companies' revenues, dividends or other corporate metrics.
Some smart beta indexes focus on volatility. For instance, a low volatility index strategy might measure the performance of the 100 least-volatile stocks in the S&P 500. In this scenario, the index components might be weighted relative to the inverse of their corresponding volatility, with the least volatile stocks receiving the highest weights.
Smart Beta Considerations
There can be potential advantages to smart beta, including diversification through exposure to indexes that do rely on price or market weighting. However, products tracking smart beta indexes can also carry investment risks, and returns for these products may be very different from investments that track market cap-weighted indexes. Not only might these indexes be complex or unfamiliar to investors, they may also have higher expenses.
If you’re considering a product linked to a smart beta index, or have been contacted about purchasing such a product, it's important to understand how the index the product tracks is constructed, what factors are claimed to be captured, and whether it helps meet your overall investment objectives.
Here are six "smart" questions to ask before investing in a product linked to a smart beta index:
1. What’s the product's strategy? Read the prospectus and talk to your investment professional to make sure you understand the strategy and how it fits with your investment objectives. It's also a good idea to visit the index provider's website to learn more about the index’s methodology.
2. What are the costs? Products that track smart beta strategies are usually less expensive than actively-managed funds but tend to be more costly than funds that track market cap-weighted indexes. This is due in part to the fact that smart beta indexes rebalance their holdings—selling and buying securities to stay within the boundaries of their strategies—more frequently than market cap-weighted indexes. This turnover can increase investor costs.
3. What are the potential advantages? Smart beta products vary, and so do the reasons to include or not include them as part of an overall investment strategy. For example, some indexes use factors such as company growth rate, income or other criteria for stock selection, which may or may not be useful to your overall investment strategies and goals. Visit the index provider's website for information on potential advantages, and weigh them against any potential risks.
4. What are the potential risks? Risk factors are outlined in a product's prospectus and will vary by product. In particular, look to see if the fund is more heavily weighted in a particular sector or country, or toward a particular size of company. For instance, is it more exposed to small-cap stocks? Because of their unique methodologies, smart beta strategies can be less diversified than other investment strategies. This is known as concentration risk.
5. How liquid is the product and its holdings? Because many of the exchange-traded products (ETPs) tracking smart beta indexes are relatively new, the ETPs themselves might be thinly traded and have wide bid/ask spreads, which can increase both the cost and risk of investing. The liquidity of these underlying holdings might affect the liquidity of the product tracking the smart beta index.
6. Are the performance figures back-tested? Many alternatively weighted index strategists claim their approaches beat the market based on historical back-testing. To support this claim, the strategists generate hypothetical performance results by applying a mathematical model to historical market data. While back-testing is helpful, it neither predicts future performance nor perfectly replicates previous performance.
Be smart when evaluating smart beta products. Such products are by no means guaranteed to outperform more traditional index products. And as with all securities products, they carry risks and costs.