How Smart Beta Could Help in a Frothy Market?
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How Smart Beta Could Help in a Frothy Market?

Smart beta funds have seen tremendous growth over the past few years.

In 2016, BlackRock predicted that smart beta ETF assets could reach $2.4 trillion by 2025. Smart beta fund assets surpassed $560 billion in 2019 and continue to play an important role in both individual and institutional portfolios across equity and fixed income markets.

Let’s take a closer look at smart beta funds, strategies for frothy markets and funds to consider for your portfolio.

Learn more about portfolio management on our Portfolio Management Channel.

What is Smart Beta, Really?

Smart beta is an enhanced indexing strategy that captures factor exposures using a systematic, rules-based approach. Unlike passively managed funds that attempt to match a benchmark, smart beta funds attempt to outperform, maximize income, reduce risk or achieve other objectives using a systematic approach that sets them apart from actively managed funds.

Most smart beta funds fall into a few categories:
 

  • Factor-based strategies look at specific attributes of a security to weight the portfolio, such as price-earnings ratios or credit quality.
  • Equal-weight strategies take all factors into account to weight a portfolio evenly rather than by using market capitalization.
  • Low-volatility strategies weight securities based on their historic price volatility in an attempt to reduce future volatility.

The performance of smart beta funds depends on the specific fund and the benchmark comparison. For example, most passively managed fixed income funds are weighted by the size of the bond issue, which could actually favor more highly indebted companies. A smart beta fund might consider credit risk as a factor and reduce the overall default risk.

The biggest drawback of smart beta funds is that they often carry higher expense ratios than passively managed index funds – although these expense ratios tend to be much lower than actively managed funds. Investors must weigh the impact of higher fees with the potential performance improvements or risk reductions in their portfolios.

Use the Mutual Funds Screener to find the funds that meet your investment criteria.

Strategies for Frothy Markets

The financial markets have long been characterized by a boom-bust cycle. While timing the market rarely works, shifting asset allocations can help reduce risk without the opportunity cost of going to cash too early. Smart beta funds can help make these shifts without the use of expensive – and often questionable – active investment managers.

There are a few strategies to consider in frothy markets:
 

  • Fundamental smart beta funds can help reduce risk by shifting from growth to value. For example, companies with little debt and strong free cash flow may be better positioned to weather a downturn than a high-flying tech stock.
  • Low volatility smart beta funds can reduce risk by targeting equities with less volatility than the overall market. While it’s not a guarantee of future volatility, these funds tend to pick equities in sectors that have less volatile exposure (e.g., utilities).
  • Balanced risk smart beta funds in fixed income can reduce risk by factoring credit quality into the mix or lower interest rate risk by factoring in duration. Other funds may try to balance credit quality with income to maintain a desirable yield.

Smart beta funds don’t have to be an all-or-nothing proposition – they can be incorporated alongside passively managed funds in a portfolio.

Smart Beta Funds to Consider

Here are few mutual fund options that implement a smart beta strategy
 

Here are few ETFs that implement a smart beta strategy

The Bottom Line

Smart beta strategies offer an opportunity to hedge against risks during frothy market conditions. With a focus on low-volatility or fundamental factors, investors can insulate their portfolios from secular declines and minimize risk factors.

Make sure to visit our News section to catch up with the latest news about mutual fund performance.

ETF and mutual fund data as of February 24, 2021
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Feb 24, 2021