The Lowdown on Smart BetaSep 30, 2017

Chandra Seethamraju, PH.D., Vice President, Director of Systematic Modeling, Franklin Templeton Solutions, provides the “lowdown” on smart beta. In this video he covers:

  • The difference between regular and smart (or strategic) beta
  • Factors and why they are an important driver of performance
  • How smart beta seeks to deliver strong risk-adjusted performance

Transcript

Hello. I am Dr. Chandra Seethamraju and I'm here to give you the lowdown on smart beta.   

Ok.  You may be thinking:  Why do I need the lowdown on smart beta?  Well, what if I told you it could completely change the way you think about index funds?  Better yet, what if I just told you it may make you a smarter investor?

But before we talk about smart beta, let's take a quick step back.  And, let's talk about just good old, regular beta. 

What is it exactly?

In the world of investing, beta has traditionally been a measure of the volatility of a security or a portfolio relative to the stock market as a whole.  Here is a newer term that you might not know - cheap beta.  Hmm, cheap beta.  You may be thinking, if beta equals volatility relative to the market, how can it be cheap – or expensive - for that matter?

Well, nowadays the word beta is also used as shorthand to describe getting broad stock market exposure - typically through investments that often track the S&P 500 and other large indices.

So, cheap beta refers to getting this exposure cheaply - for example, through exchange traded funds that track large indexes such as the S&P 500.  But is that really the smartest way to get exposure to the stock market?

These ETFs typically are market capitalization weighted.  Simply put, it means big companies are automatically a bigger part of the portfolio, while smaller companies are a small - often teeny, tiny - part of the portfolio.  Which of these companies are the best value doesn't even enter into the equation. Not exactly rocket science.  But, of course, you get what you pay for.  If only there was a more thoughtful way to get broad exposure to the market in a systematic fashion.

Thankfully there is, and this is where smart beta comes in.  Smart beta funds are based on time-tested factors that have historically driven stock performance.  What's a factor, you say? Factors are attributes of stocks or portfolios.  Well, take quality for example.  It considers a company's profitability and balance sheet. 

A smart beta fund might start by looking at the same stocks that are included in a cap weighted index, but applying a quality factor would mean that it would only invest in the sub-set of companies with healthy profits and strong balance sheets.  Other popular factors are value, momentum and low volatility.  And, similar to the quality factor, they emerged from extensive academic research.

To sum it up, investing in a capitalization-weighted ETF will give you exposure to the stock market, including inadvertent exposure to many stocks or attributes that may be less than ideal.  By contrast, a smart beta ETF only invests in certain stocks from the broader index depending on what factors it has dialed up and how they are applied. This is why they are called smart -- because they deliberately strive for more than just market exposure, they seek to deliver risk-adjusted performance that is better than the benchmark index.

Thank you for joining me to learn about smart beta. Have a great day.

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