Issue 28: 2014

Investment Strategy

Getting to Know Smart Beta

An increasingly popular alternative (or complement) to traditional passive and active investments, smart beta is worth a closer look.

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Both the number and variety of “smart beta” investment products have been growing rapidly in recent years, and investors can’t seem to get enough. But what are they exactly? And are they worth your time?

We can break down investment strategies into two broad categories — passive and active. Passive investing doesn’t attempt to time markets or pick winning stocks; often, the goal is to simply mirror the components of a market index and thereby track the performance of that index, which is why passive investing is sometimes referred to as “indexing.” Active investing strives to outperform the market — and passively managed funds — using a wide variety of techniques, including market forecasts, fundamental and other analysis, style and sector allocations, and individual stock selection — all of which are ultimately governed by the experience, analytical skills and judgment of investment managers. Management fees of actively managed products tend to be higher than those of passively managed investments to compensate for this skill.

And smart beta investing? It fits in between passive and active investing strategies. Although they are technically passive investments (with advantages similar to passive investments when it comes to fees and other costs), their objective is to perform better than traditional passive investments. How do they do this? While most passive investments tend to own the entire market or segment (proportionally anyway), smart beta strategies deviate from traditional market cap weights and instead typically employ weighting schemes based on fundamental factors such as book value, risk and dividends, or simply weight all securities equally. Sometimes, smart beta frameworks are set up to select only stocks that demonstrate certain characteristics, such as value, high momentum or low volatility. Emphasis on these characteristics may not always lead to performing better than the market, but some of these characteristics appear to have led to better performance over long time periods in the past.

What is smart beta investing? It fits in between passive and active investing strategies.

While smart beta products may not provide the sorts of returns or potential added value that actively managed products aim to deliver, they do appear to offer benefits above and beyond those of traditional passive investments, and could well be worth considering as alternatives or complements to existing active and passive products in your investment portfolio. Recent underperformance of active management has also increased the interest in and desire for low-cost, efficient smart beta alternatives.

In the end, smart beta is another important tool for building investment portfolios. Investors can now choose to invest passively via traditional passive or smart beta products, or aspire to above-market returns using actively managed products. Depending upon your goals, all three approaches could be useful in your investment portfolio.

For more information on smart beta investing and its origins, read "The Evolution of Smart Beta" and contact your advisor.

IMPORTANT INFORMATION

Investing involves risk. There is always the potential of losing money when you invest in securities.

Always consult with your independent attorney, tax advisor, investment manager and insurance agent for final recommendations and before changing or implementing any financial, tax or estate planning strategy.

OTHER IMPORTANT INFORMATION

Equities
Equity securities are subject to stock market fluctuations that occur in response to economic and business developments.

International Investing
International investing involves special risks, including foreign taxation, currency risks, risks associated with possible differences in financial standards, and other risks associated with future political and economic developments. Investing in emerging markets may involve greater risks than investing in more developed countries. In addition, concentration of investments in a single region may result in greater volatility.

Both the number and variety of “smart beta” investment products have been growing rapidly in recent years, and investors can’t seem to get enough. But what are they exactly? And are they worth your time?

We can break down investment strategies into two broad categories — passive and active. Passive investing doesn’t attempt to time markets or pick winning stocks; often, the goal is to simply mirror the components of a market index and thereby track the performance of that index, which is why passive investing is sometimes referred to as “indexing.” Active investingstrives to outperform the market — and passively managed funds — using a wide variety of techniques, including market forecasts, fundamental and other analysis, style and sector allocations, and individual stock selection — all of which are ultimately governed by the experience, analytical skills and judgment of investment managers. Management fees of actively managed products tend to be higher than those of passively managed investments to compensate for this skill.

And smart beta investing? It fits in between passive and active investing strategies. Although they are technically passive investments (with advantages similar to passive investments when it comes to fees and other costs), their objective is to perform better than traditional passive investments. How do they do this? While most passive investments tend to own the entire market or segment (proportionally anyway), smart beta strategies deviate from traditional market cap weights and instead typically employ weighting schemes based on fundamental factors such as book value, risk and dividends, or simply weight all securities equally. Sometimes, smart beta frameworks are set up to select only stocks that demonstrate certain characteristics, such as value, high momentum or low volatility. Emphasis on these characteristics may not always lead to performing better than the market, but some of these characteristics appear to have led to better performance over long time periods in the past.

Depending on your goals, all three approaches could be useful.

While smart beta products may not provide the sorts of returns or potential added value that actively managed products aim to deliver, they do appear to offer benefits above and beyond those of traditional passive investments, and could well be worth considering as alternatives or complements to existing active and passive products in your investment portfolio. Recent underperformance of active management has also increased the interest in and desire for low-cost, efficient smart beta alternatives.

In the end, smart beta is another important tool for building investment portfolios. Investors can now choose to invest passively via traditional passive or smart beta products, or aspire to above-market returns using actively managed products. Depending upon your goals, all three approaches could be useful in your investment portfolio.