Wharton@Work

August 2015 | Finance

How Smart Is Smart Beta?

Smart beta funds, the relatively new kids on the investment block, are growing in popularity. They attracted $59.34 billion in 2014, according to Morningstar, and new smart beta products are being introduced as more providers enter the market. For individual investors, they look like an attractive option. But before investment advisors recommend them, they need to understand what drives fundamental index strategies — and when they belong in their clients’ portfolios.

“These funds have received quite a bit of attention over the past ten years, in part because some of them outperformed the S&P 500 through the financial crisis,” says Wharton finance professor Craig MacKinlay. “But they use a broad range of strategies, and they do not all work the same way. If you haven’t analyzed each one you are interested in, you might not understand the risks involved.”

MacKinlay teaches participants in Wharton’s Investment Strategies and Portfolio Management how to perform those analyses, and much more, during the five-day program. “We focus on providing tools and breaking down investing strategies to understand what drives them,” he notes.

Unlike traditional funds that track market capitalization-based indices (a strategy that potentially overweights overvalued stocks), smart beta products track other measures (or “fundamentals”), such as earnings, sales, book value, dividends, and volatility. The hope is that they will provide greater returns, lower costs, and reduce risk in today’s uncertain economic environment.

“Smart beta strategies originated about 15 years ago, when Rob Arnott came up with idea of fundamental weighting,” explains MacKinlay. “These strategies are relatively passive — they generally have mechanical, transparent rules behind them. For example, one simple strategy is to invest only in lower risk stocks. Such a strategy has done better than anticipated historically. When you look at Warren Buffet’s investments over the last 40 years, you can see he tended to concentrate on lower risk investments. It’s an interesting coincidence.”

MacKinlay says most of the advisors who attend Investment Strategies and Portfolio Management have heard about smart beta strategies, but often don’t fully understand them. They are typically compared to traditional index funds, “That comparison can be misleading and it’s not appropriate,” he notes. “Smart beta strategies are different. They usually focus on different segments of the market. You need to know the sector or style you are going to be exposed to by doing a detailed analysis. There is more to smart beta than just another passive investment strategy.”

To what extent will smart beta continue to perform well? “It’s an open question,” he says. “You can’t count on a free lunch in investing.” That said, should smart beta have a role in your clients’ portfolios? It depends on the client and on the existing portfolio. But armed with new knowledge, managers can help them make better decisions.