What is smart beta?

Oct 13, 2023 By Triston Martin

Smart beta refers to using quantitative analysis to determine whether or not a stock is undervalued. What does it mean? And why should I care?

When investors look at stocks, they often focus on price alone. They ignore other vital metrics such as earnings growth, cash flow, and valuation. These metrics are fundamental indicators because they provide insight into the company.

A smart beta fund uses these fundamental measures to identify undervalued companies relative to their peers. The idea behind smart beta investing is that it allows investors to invest in cheap companies compared to the market average.

Explaining The Smart Beta

Smart beta is a type of investment analysis that uses quantitative methods, such as mathematical algorithms, to identify and track the performance of stocks and other securities that may be undervalued. The goal of smart beta is to provide investors with a more efficient way to allocate capital to securities while achieving the same or better returns than traditional methods.

Smart beta is a growing area of investment analysis and has been gaining popularity in recent years. Smart beta is based on the idea that specific stocks and securities are undervalued and, as a result, offer investors potential returns that are above average.

The key to smart beta success is finding undervalued securities and then tracking their performance. This can be done using a variety of methods, including mathematical algorithms. By using the smart beta, investors can achieve the same or better returns than traditional methods while reducing the overall risk of their investment portfolio.

Moreover, smart beta ETFs must completely track the S&P 500 and the NASDAQ. However, they follow indices and keep other factors in mind, such as size, quality, liquidity, and momentum. They mainly concentrate on different market areas where they may find an opportunity for exploitation.

Smart Beta Working

Many of you would need to learn that beta applies to investing. Beta measures the stock’s volatility compared to the market overall. If we talk about S&P 500, its beta is declared as 1. If the beta has a higher value than 1 for a particular stock, this shows it is more volatile than the S&P 500. So, the more the beta value, the more volatility will be compared with the S&P 500.

The beta value also has a direct relation with risk. This means the higher the beta value, the riskier the investment. But at the same time, it can provide great returns. When the S&P increase 10 percent in value, a stock with a beta value of 1.3 would increase by 13 percent. This is the same for the increase and decrease. On the other hand, stocks with a beta value lower than one will be less risky but offer lower returns.

Advantages of Smart Beta

1. Many Investing Strategies

Every investor has a different investing style; to match it, smart beta ETF ( Exchange Traded Funds) offers investors various strategies. Investors are always concerned about which strategy they should choose, which helps them make the best investment decision that can double their returns.

2. Not Too Expensive

Smart beta ETFs have lower charges than other actively managed funds. Although these ETFs' expense ratio is relatively high, it’s lower than actively investing funds.

3. Smart Beta is Outcome Oriented

This means it improves your ability to focus on the result rather than the complicated process and tactics. This enhances their belief that nothing is more essential in achieving your goals. Investors may align the results with their preferences, such as cost and risk.

Drawbacks of Smart Beta

1. More Expenses as Compared to Index Funds and Low Liquidity

Few people invest in smart beta ETFs, so they often have low volatility due to low volume. This also decreases liquidity in the ETF.

Moreover, it is more expensive than index funds which can attract many investors to shift from smart beta ETFs to index funds.

2. Not Quite Reliable

There must be proof that smart beta strategies are reliable and have posted great returns. When the performance of smart beta ETF was compared with the blended benchmark in research, no consistent results were witnessed over the years. This research highly questions their reliability.

Difference Between Alpha and Beta

There is often a misconception that alpha and beta are the same, but that is not true. You all know that beta measures volatility and has a baseline of one. However, alpha measures the difference between the actual performance and the output that we were expecting. The baseline of alpha is also zero.

If the S&P has returned an ROI(Return On Investment) of 10 percent and a fund has an ROI of 12 percent, the fund will have an alpha value. If there is a fund that has an ROI less than the S&P 500, it would have a negative alpha value higher than one. Investors are attracted to funds with a higher alpha value, which shows that this fund has more ROI than the S&P 500. So, the higher the alpha value, the better it is.

Many investors also balance the alpha with the beta for better results, mostly those with a defensive investing approach. Finally, you must remember that future results are never guaranteed, and the alpha value will only sometimes remain consistent.

Final Thoughts

Investors have become increasingly interested in using data analytics to improve their investment decisions. The idea behind smart beta is to combine the power of machine learning with human judgment to create better investment strategies. Smart beta has become increasingly popular over the last decade. The idea behind smart beta investing is to reduce volatility and increase returns. There are two main types of smart beta strategies, fundamental and technical. Fundamental beta focuses on analyzing a company's financial statements and earnings reports. Technical beta uses advanced mathematical models to predict future stock prices.

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