Smart Beta Revealed

The terms "Smart Beta" or "Strategic Beta" are used to describe a category of index-tracking funds that don't follow traditional market-capitalization-weighted strategies. The long-term goal of these funds is to achieve "better-than-market" returns or "market-type" returns with less volatility.

Traditionally, a stock market index is "market-capitalization-weighted," which means that the larger a company is, based on its market capitalization (# of shares outstanding x price per share), the larger is its allocation in an index. For example: The S&P 500 index contains 500 stocks, but this doesn't mean that each stock counts equally. Apple is the largest U.S. stock and comprises 3.8% of the index; followed by Microsoft at 2.9%; Amazon at 2.1%; and Facebook at 1.9%.

The S&P 500 is actually a very concentrated index:

• Top 10 stocks     -           20% of the index
• Top 25 stocks     -           34% of the index
• Top 50 stocks     -           49% of the index
• Top 75 stocks     -           58% of the index
• Top 100 stocks  -            65% of the index
• Top 200 stocks  -            82% of the index
• Top 300 stocks  -            90% of the index

So, the bottom 200 stocks account for just 10% of the index.

Not only is the S&P 500 (and all other market-capitalization-weighted indexes) a very top-heavy index, it is also a "price momentum" index. If the price of Apple or Amazon or any other stock in the index goes up at a faster rate than other stocks in the index, it occupies a greater percentage of the index, so funds seeking to track the performance of the index must now buy more of those stocks. Why? Not because of any fundamental reason, but simply because the price went up.

Smart Beta breaks this link with share price by creating indexes that are not market-capitalization-weighted indexes.  Smart Beta funds may use a variety of alternatively-weighted measures to determine their allocations, such as:

• Fundamentals (sales, cash flow, dividends, book value)
• Revenue-weighted
• Dividend-weighted
• Equal-weighted

A by-product of Smart Beta strategies is that they have "factor tilts." This means that when you construct an alternatively-weighted index, the end result is an index that is tilted heavier towards companies displaying attractive factors such as:

• Lower volatility
• Smaller company size
• Higher quality
• Higher dividends
• Lower price, relative to earnings or book value

Historically, these "factors", over longer periods of time, have proven themselves to be persistent, consistently delivering results.

How are Smart Beta funds used in a portfolio?

If you invest in individual securities or actively-managed funds, you may have little interest or need for Smart Beta funds in a portfolio. Active management - by definition - means you are already seeking to invest differently than traditional broad market indexes.

If you invest primarily in index-tracking mutual funds or exchange-traded funds, incorporating some Smart Beta funds into a portfolio provides further diversification and potentially enhances long-term returns by having a portion of the portfolio decoupled from traditional market-capitalization-weighted strategies.

Smart Beta indexes and the funds that track them are not a short-term investment strategy. In periods where larger companies perform better than smaller companies or more expensive "growth" stocks dominate over less expensive "value" stocks - Smart Beta funds will most likely underperform. However, for those with a long-term perspective, blending Smart Beta investments into a traditional portfolio may turn out to be very smart indeed.

Gerald A. Townsend, CPA/PFS/ABV, CFP®, CFA®, CMT is president of Townsend Asset Management Corp., a registered investment advisory firm located in Raleigh, North Carolina.  Email:   Gerald@AssetMgr.com