There are plain-vanilla beta market capitalization strategies, and then there are smart-beta market cap strategies, the next generation.
Within a market cap index, the market value of each stock is the number of shares outstanding times its current market price, says Tom Goodwin, senior research director at global index provider FTSE Russell in New York.
“This incorporates everything that is known currently about the company, plus forecasts of how the company might do in the future,” he says. “What we strive for is an accurate snapshot of the economy at any one point in time.”
If investing in the indexes via a mutual fund or an ETF, an individual is investing in the whole market, and the value goes up or down with the whole market, Goodwin says.
However, smart-beta strategies typically have different criteria for within stocks in a cap-weighted index. The simplest smart-beta index would be an equal-weighted index, weighing all the stocks equally, which gives different return and risk patterns.
“All of the smart-beta indexes can have periods of outperformance, but they can also have periods of underperformance, compared to cap-weighted benchmarks,” Goodwin says. “This is a very active research area on how to combine these portfolios.”
Traditional market-cap strategies are considered “generation one” of passive investing, says Anthony Davidow, alternative-beta and asset allocation strategist at the Schwab Center for Financial Research in New York.
Smart-beta strategies are the next generation or “passive investing evolved” and can be broken down into many subcategories, including fundamental index, low volatility and equal weight, he says.
Part of the appeal of these strategies is that they intend to improve upon the market experience, Davidow says.
Some strategies are designed to enhance returns or strategies focused on either high-beta or low-beta strategies, depending on a client’s risk tolerance.
“We view market cap and fundamental index strategies as complementary. We think they go better together,” Davidow says.
“Combining them can provide a better diversified portfolio as the different weighting methodologies can allow an investor to be rewarded in multiple environments,” he says.
For example, last year, investors were better served with a market cap portfolio, as many momentum stocks ended up being reflected in a market cap portfolio.
But this year, investors that are exposed to stocks with attractive fundamental characteristics, like those in a fundamental index strategy, will benefit, according to Schwab’s research.
Fundamental index strategies break the link with price by screening and weighting securities based on sales, cash flow, dividends plus buybacks, so Schwab experts think that they will outperform late in a bull market.
“We like fundamental strategies now because we’re in a market environment experiencing a fair amount of volatility and frankly in the latter stages of a bull market, and we believe fundamentals make a lot of sense in this environment,” Davidow says.
Claudia Mott, a CFP and the principal of Epona Financial Solutions in Basking Ridge, N.J., says that smart-beta funds may provide a bit of excess return as a result of their special features, but it isn’t clear whether they have provided the kind of performance that warrants their inclusion as a core holding.
“But for those wishing to have a particular tilt in their portfolio, these funds may provide that opportunity,” she says.
This story is part of a 30-30 series on ways to build a better portfolio.