08/14/2014 05:10 EDT | Updated 10/14/2014 05:12 EDT

How Smart is Smart Beta, Really?

It has been said that in investing, what is comfortable is rarely profitable. This perhaps explains why the investment landscape is littered with novel and sometimes unsuccessful money making strategies.

Especially in the aftermath of the 2008 financial crisis, the investment industry is on the hunt for better, yet safer ways to increase returns on an investment. This has given rise to a number of alternatives to standard investing strategies that seek to give investors the best of both worlds -- maximum returns with minimal risk.

Most recently, Smart Beta investing strategies are causing a stir among investors. Some believe that Smart Beta offers a more efficient approach to investing than incumbent strategies, while others regard it as a marketing ploy that will eventually fade away.

Alpha, Beta and traditional investment approaches

Conventional investing falls into one of two categories -- active or passive, each with different elements of risk and return represented by the risk ratios alpha and beta. Alpha is often considered to represent the value that an investment manager brings to a fund's return. If a fund has a positive alpha it mean it outperformed the market, if it is negative it underperformed.

Beta is a measure of volatility; it looks at how a security or portfolio will move against the market as a whole. A security or fund with a beta greater than 1 is considered more volatile than the market; less than 1 means less volatile. So, let's say that you invest in a fund with a beta value of 1.3; theoretically it is 30 per cent more volatile than the market.

An active investment strategy is carried out by a trained financial investment professional and requires complex analyses and monitoring of market conditions. Active investors typically seek short-term profits with the goal to generate returns higher than the average market performance. In other words, their intention is to "beat" the market with a comparison to a benchmark like the TSX. The fees incurred by an investor using an active strategy are generally higher, as active investing involves a combination of fundamental and technical analysis, and a micro and macro analysis of current and pending market conditions as well. Essentially you pay more on active management due to the level of work the manager has to do in an effort to provide alpha and beat the market average.

In contrast, a passive strategy is focused on the longer-term, with the intention of making money based on the collective outcome of all stocks and bonds in an index fund. Using a weighted approached based on the market capitalization of the companies in certain indexes such as the TSX or S&P 500, passive investing only needs to maintain the appropriate weightings to match the index performance. The fees for an investor are much lower because there is no significant research or analyses involved; however, investors also lose the opportunity to "beat" the market when they make investments using a passive strategy.

So what makes Beta 'smart' and why are people listening?

Smart Beta is positioned at the intersection of active and passive investing and claims to offer a third choice to investors. Referred to as a hedge fund beta or strategic beta, Smart Beta has been described as an "active approach to passive investing"; allowing the opportunity to beat the market with strategic analysis when picking investments, but limiting fees by rolling investments into a fund that requires limited professional investment once launched.

In theory, it claims to offer investors this best of both worlds scenario. In contrast to the market capitalization approach of traditional passive investing, smart beta uses alternative indicators such as valuations, momentum and dividends, to select the weight of each stock, giving investment managers more options on how stocks are weighted within a fund.

The verdict

Following a polarized discussion at the recent CFA Institute Annual Conference this year, a poll of CFA Financial NewsBrief readers indicated that only 17 per cent of nearly 700 readers found Smart Beta to be a worthwhile innovation that can enhance return or reduce risk, whereas 27 per cent believe that it is simply a passing fad. 38 per cent of respondents said that they needed additional information to form an opinion and the remainder didn't have an opinion, or believed that it was too early to judge Smart Beta decisively.

From an investor's viewpoint, smart beta offers some of the advantages of active managed investing, without the fees associated with active managers; however the fees incurred will be higher than traditional passive investing. There is also the possibility of significant transaction costs from periodically rebalancing non-market capitalization weighted indexes that can negatively affect investment returns.

In order to avoid some of these unintended risks, investors need to ensure that they understand the index strategy and that any indexes they invest in are simple, transparent, and rules based. They also need to be able to commit to the strategy for the long term.

Ultimately, only time will tell if some or all of these strategies will prove to be effective and continue to hold the market's interest. In the meanwhile, those of you that are interested in learning more about this topic can visit us at