What are Smart Beta Investments?

I went to an ETF conference in Dana Point, CA recently and “Smart Beta” funds were all the rage. You have probably heard of them if you’ve read the financial news, but what are they exactly?

They sound good. With the word “Smart” in the title they must be good, right? We’ll get to the reason they are called “smart” later, but first, what does the “Beta” part of the name mean? “Beta” is financial jargon for the base, overall risk and reward of the market. If you own every stock on the stock market, you are exposed to the entire range of risk and reward in the market. That’s the Beta part of “Smart Beta”.

The first ETF created was the SPiDeR S&P 500 ETF (NYSE: SPY). The idea behind it was to create a fund that holds stock in every company in the S&P 500 stock market index. Because it holds every stock in the market, it is a Beta investment.

For a couple of decades everyone was happy with this idea. Invest in a market index fund like SPY and get what the market gives you. If you stay invested, and if the future is like the past, you should have more money in your account with the passing of time. Just buy and hold.

Eventually someone thought it might be possible to improve on the idea of holding every stock on the stock market. After all, aren’t some of them dogs? Companies struggle. Entire industries die out. For instance, one doesn’t want to own typewriter companies when personal computers become commonplace. What if we sort out only the quality companies on the stock market and invest in just those companies? That would be smart, right?

Ah-ha! Smart Beta. Smart because the fund picks a portion of the market with improved odds of higher returns and Beta because it takes what those stocks give without timing repeated buying and selling.

ETF.com currently lists 764 funds on its Smart Beta channel. The fund companies have come up with a lot of different ways to slice up portions of the stock market they think may be better investments than the market as a whole. This trend has shown no sign of ending anytime soon. Some of the ideas will work, others will not. Deciding which Smart Beta funds to buy is a topic for another day.

 

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What are Smart Beta Investments?
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