The popularity of index style investing has grown to all time highs. Now that investors have come to recognize it as an intelligent solution, we see the significant development of products marketed as “smart beta”. I get a lot of questions on the topic that goes by a variety of names including enhanced or fundamental indexing. Jargon aside; this column is an effort to put into context this evolution of index investing.
Indexing has been around for over 40 years. The initial idea was a simple one. Identify all of the companies that are publicly traded, assemble a list, buy all those companies and weight their exposure based upon their overall footprint. It’s called market cap weighting or cap weighted indexing and it continues to be the largest methodology used today.
Over time indexing evolved. Indexes expanded far past the familiar 500 largest companies in America represented by Standard and Poor’s S&P 500. When someone decided to use a different sorting method, (let’s call it non-market cap weighting) to build an index, we entered an era that today many reference as “smart beta.”
First, I’m not sure if beta (a well know measure of volatility relative to the market) can work in the context of being “smart.” It’s not doing any thinking nor actively making decisions. It’s simply following the initial programming that it was created with. When you hear “smart beta” think filtered beta. The product creator has decided to sort or filter the index to gain a different type of exposure to the underlying companies.
There are an endless number of possibilities, many of which have academic grounds and others that were created because, like many financial products, they’re easy to sell. Identifying which ones are viable can be difficult. Many target well know academic factors such as size, value or momentum.
Let’s say that you believe in this research and want to build a value factor “tilt” (more jargon that simply means increased exposure) into your portfolio. Value can be defined with a variety of different metrics (low price-to-earnings, price-to-book, and price-to-sales ratios, and high dividend yields.) Here's where you run into a problem. Which one to use?
If it makes sense to target a single factor, doesn’t it may make sense to target multiple factors? Some, such as momentum and value have historically been proven to work well together. However, attempting to blend two separate products to reap the reward may present a problem because of the different ways that the underlying index is defined. Therefore, to achieve the desired exposure, any argument for smart beta should be in the same context of how one fund interacts with the rest of the portfolio.
To me “smart beta” isn’t really smart, its just non-market cap weighted indexing that’s been filtered or repackaged. However, that doesn’t mean it’s stupid. Stupid would be investing in fund marketed as “smart beta” because the fund company had a great pitch. We may as well get used to these discussions. Smart beta products are popular and there are tons more coming down the pike. It’s important to understand how one funds interacts with the rest of your portfolio. At Wealthshape it’s our job to filter this environment, separate the fluff, and deliver solutions that have the backing empirical research, not marketing.
Timothy Baker, CFP® is the Founder and CEO of Wealthshape LLC, a firm built on the belief that investment advice should rely on long term, proven academic evidence and everyone should have access to it. Wealthshape engineers advanced, institutional grade portfolios that are responsibly delivered at a low cost to investors from all walks of life.
By Tim Baker, CFP®
Advice and investment design should rely on long term, proven evidence. This column is dedicated to helping investors across the country, from all walks of life to understand the benefits of disciplined investing and the importance of planning.