ETF – So, Just What is “Smart Beta”?

ETF – Smart Beta – They seem to promise what all investors are seeking: higher returns and lower risk. That should prompt skepticism.

The financial engineers of Bay and Wall Streets love coming up with new jargon. Typically these terms have more to do with marketing and selling new products than with sound investment principles. The latest one to be bandied about by the ETF industry is “Smart Beta” So, just what is “Smart Beta”?

ETF Smart Beta

ETF – So, Just What is “Smart Beta”?

Beta is a measure of the volatility, or systematic risk of a security or a portfolio in comparison to the market as a whole. The term “Smart Beta” is now being appended to crop of new exchange traded funds (ETF’s). They seem to promise what all investors are seeking: higher returns and lower risk. That should prompt scepticism. Before exploring what the term smart beta actually means, let’s recall what ETF’s are.

ETF’s are investment funds that trade on stock exchanges, much like stocks. As with mutual funds, ETF’s holds assets such as stocks, commodities, or bonds.  Many ETF’s track an index, such as the S&P/TSX Composite here in Canada or the S&P 500 in the US. Others track market sub-sectors, such as the S&P/TSX Capped Energy index.

Why are ETF’s so popular? Low management fees are likely the main reason. ETF fees are in the 0.5% range, compared with 2% to 3% for many large Canadian mutual funds. The pitch from the ETF industry goes something like this: your mutual fund isn’t out-performing the market, so why are you paying high management fees? Why not just buy the index? Your performance will match the index and you will pay much lower fees.

Many ETF’s are ‘capitalization-weighted’, meaning that stocks in the funds are weighted in proportion to their market capitalization. For example, in a fund that tracks the S&P/TSX Composite Index, Royal Bank, with a market capitalization of $105.66B, will form a higher proportion of the fund than Westjet, with a market capitalization of $2.97B.

In smart beta funds, the component weightings are based on other criteria, such as valuations, dividends, momentum or volatility. By a curious coincidence these are the same sort of criteria that active managers use to look for stocks. Of course, active managers use these criteria simply as a screen: stocks that meet a given criteria are then subject to thorough analysis prior to being selected. In a smart beta fund all stocks that meet the criteria are included in the fund.

The ETF industry has said that active management can’t beat the index, so investors should just hold index ETF’s. Now they are saying, that they are smarter than traditional managers and that their smart beta products offer better than market returns at low cost. Sound too good to be true, doesn’t it?

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