beta

How Smart is Your Beta?

beta

At Index Fund Advisors, we are always keeping an ear out for new terminology that appears in the investment marketplace. Recently, there has been a lot of talk about “smart beta”. Recall that beta, in its strictest sense, refers to the degree of market exposure or sensitivity to the market of either an individual security or a portfolio. It was coined by Nobel Laureate William Sharpe as the centerpiece of his Capital Asset Pricing Model (CAPM). Although technically incorrect, beta has been expanded to include other risk factors beyond market such as size and value, and this is where “smart beta” comes into play. 

Although we have known for decades that exposure to small cap and value companies imparts a higher expected return at a cost of higher risk, it seems that there is no shortage of ways of obtaining these tilts such as small/value cap-weighted indexing, fundamental indexing, equal-weighted indexing, et al. Is one way of obtaining factor exposure necessarily smart while another is necessarily dumb? Not really.  

Please understand that while there are things that an index fund provider can do to protect its shareholders such as not being forced to trade on a given date merely because the target index has been reconstituted, at the end of the day, the performance of a diversified portfolio is explained by its structure. If we assume that all securities are fairly priced to reflect their risks and expected returns, then there is no smart or dumb—just more risk or less risk.

Like many if not most new terms that appear in the investment marketplace, smart beta was created to cause investors to question whether their current holdings are adequate and to make them feel insecure about whether their portfolio will keep up with their peers’ portfolios. It’s almost as though they are saying, “Hey we know you aren’t going to get alpha, but here’s the next best thing.” Naturally, since smart beta is better than just ordinary beta, you should be happy to pay more for it.

As always, Index Fund Advisors counsels investors to tune out the noise and distractions of the investment marketplace. Beta (along with the other risk factors) can only be considered smart when it is taken in an amount that is appropriate for a given investor. To determine the amount of risk that is right for you, please take IFA’s Risk Capacity Survey.