I’m not a big fan of marketing terms created for the sole purpose of making products sound better than they are.  And when investment or insurance companies do this for financial products it really gets me going.  One term that’s getting a lot of mileage right now is “Smart Beta,” commonly applied to certain exchange traded mutual funds (ETFs).  When a client asked me what it means, I realized it’s time for someone to set the record straight.  There’s nothing especially smart about Smart Beta funds, and ETFs purporting to utilize it are no better or worse than those that don’t.

In order to understand Smart Beta, you must first understand beta.  It is a measure of the risk of an individual security arising from exposure to general market movements as opposed to factors unique to that particular investment.  For example, the price of Apple stock is affected by many factors.  Some, such as the company’s competitive situation, the quality of its management, etc. only affect Apple, while other factors such as macroeconomic events will impact all stock prices.  Beta indicates the degree to which Apple’s stock price will fluctuate based only on those latter market-oriented events.

Beta is ordinarily expressed relative to some benchmark, such as the S&P 500.  A beta of 1 means the individual security’s price variation over time pretty much matches the variation of the price of the benchmark.  A number greater than 1 means the stock price is more volatile that the benchmark, and vice-versa for a beta less than 1.  Suppose Apple stock has a beta of 1.5.  That would mean Apple’s stock price would be expected to fluctuate 1.5 times as much as the market, either positively or negatively, depending on how the market performs from year to year.  But that’s only based on overall market risk.  The price fluctuations associated with Apple’s individual company performance will still be there and, depending on the situation, could overwhelm the impact of beta.

Beta is most useful when applied to a portfolio of stocks such as an ETF or mutual fund, since the whole purpose of a fund is to diversify away everything except the market risk.  The calculation is simply the weighted average of the betas of the individual securities comprising the fund.  As with individual stocks, funds with betas higher than 1 would be expected to be more volatile than their benchmark indices.

There are some challenges with utilizing beta as a fund selection criterion.  First is the fact that as a statistical measure, beta only has meaning relative to a benchmark to which it is well-correlated.  The beta of a fund focused on small cap stocks is more meaningful when calculated relative to a small cap stock index than to a large cap stock index.  That makes it harder to compare funds in different asset classes using this measure.  The other problem is that it requires a lot of data points to make the beta calculation statistically significant.  Since most ETFs have not been around for a very long time, fund managers have to utilize proxy data from periods prior to the actual existence of the fund.  This potentially introduces errors to the measurement.

Beta can be an especially useful measure in assessing the risk of an overall investment portfolio.  But again, it is a measure of risk, not of expected future performance.   Since risk and return are positively correlated, you would expect a higher beta portfolio to perform better over time than a lower one.  But using beta as a portfolio construction metric to try to beat the market can be dangerous.  Could you stomach the bigger losses that would likely occur with a high beta portfolio when the market has a down year?  Would you have the stamina and commitment to stick with your portfolio even when it is performing worse than the market?

In my next post I’ll talk about the so-called smart beta funds and what makes them different.