Smart Beta Funds Can Differ Significantly

Smart beta strategies are promoted for being able to take advantage of specific return anomalies, however, approaches that focus on the same anomalies can vary significantly in their underlying construction.

Smart beta strategies are promoted for being able to take advantage of specific return anomalies (aka factors). These anomalies include value, company size or volatility. When smart beta strategies focus on the same return factors, however, their underlying construction can be significantly different.

Complicating matters is the overlap in what drives these strategies’ returns. As a result, investors seeking to combine different strategies targeting specific characteristics may unknowingly reduce their diversification.

An analysis by Standard & Poor’s looked at what drives the returns of smart beta factors. Here is a summary of what they found:

Value: Seeks stocks trading below their fair value. Tends to have greater price volatility and exposure to small-cap stocks.
Growth: Seeks stocks with higher-than-average revenue or earnings growth. Tends to favor stocks with higher price momentum and smaller market capitalizations. Incurs more price volatility.
Momentum: Focuses on stock with the strongest past price performance. Returns are driven by stock-specific factors, namely price movement. It is among the most risky.
Low Volatility: Identifies stocks with lower-than-average price volatility. Tends to identify value-oriented and dividend-paying stocks.
Quality: The description lacks an exact consensus, but generally targets profitable, cash-generating companies with acceptable levels of debt. Returns are driven by industry exposure, low valuations and low volatility.
Dividend: Seeks companies with high yields or targets dividend growers. Dividend growth strategies are heavily influenced by stock-specific factors. High-yield strategies’ returns are driven by dividend income or low volatility, though they can also have a significant exposure to smaller-sized companies.
Size: These strategies can either focus on smaller companies or equally weight a market-capitalization index, such as the S&P 500 index. In both cases, stock-specific factors play a big role.