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Here's everything you need to know about smart beta investing.Smart beta knows that every investor wants to beat the market. Few actually pull it off. Most of the time, a long-term, passive strategy built around reliable index funds will outperform most active trading schemes. Most of the time. Yet even index funds could use some help. This is where smart beta comes in.

What Is Smart Beta Investing?

Smart beta investing launched in the early 2000’s and has become very popular in the years since. It is an investment strategy built around exchange traded funds (ETFs).

The goal of smart beta is to build an index fund that outperforms its target index. The fund takes assets that will track a given index, then adjusts its formula to try and outperform that index by a reliable margin. Ideally, the majority of assets track the index while creating enough variety that the fund will do slightly better than the index overall.

For example, a firm might build a smart beta ETF around the S&P 500. In this case, it might first fill the fund with the stocks that make up the S&P 500 index, or others that track that index very closely. Then the fund will decide what its criteria will be to establish higher returns. It might, for example, include some smaller stocks poised for potential growth in the fund. These stocks wouldn’t ordinarily be in an S&P 500 index fund, but here they could drive it to do better than basic market returns.

Smart beta can work fairly well because most stock market indexes are built around capitalization weight. This means that they prioritize stocks in the index based on its total market capitalization. That is generally a reliable indicator of how the market is doing overall. However, market capitalization isn’t necessarily a key indicator of future growth.

Smart beta funds try to take advantage of this. They want to keep the overall stability of the market index, while incorporating some assets chosen for potential profitability.

Why Smart Beta?

Here's everything you need to know about smart beta investing.For investors, “beta” is the measure of how volatile an asset is relative to an underlying benchmark. In the case of stocks, this means it measures how volatile the stock is relative to the stock market overall, using benchmarks like the S&P 500 or the Dow Jones Industrial Average for comparison.

A beta of 1 means that the stock changes by the exact amount of the index. A higher number means greater volatility. If the stock has a beta of 1.1, this means it is historically 10% more volatile than the underlying benchmark. For example, if the S&P 500 changes by 10% expect this stock to change by 11%.

The key to beta is that it measures only of volatility, which means it can change in either direction. A stock with a beta of 1.1 against the S&P 500 will change by 10% more than the index overall. This can mean higher growth than the market, but it also means steeper falls.

Smart beta ETFs try to control this. Their goal is to improve on the overall index without letting volatility get out of control. They want to be literally smart about their beta, beating the market without losing control of their index.

Smart Beta is a Passive Strategy

Unlike actively managed mutual funds, smart beta ETFs are built around a hands-off approach.

Essentially, a smart beta fund will build a new index formula that tracks the original closely but assigns different weights and priorities based on the index’s goals. A smart beta ETF might start with the S&P 500 index, then modify the formula which produces that index to give more weight to tech companies, startups, high growth firms, low-debt firms or a wide variety of other potential metrics. Typically this formula will give priority to assets that don’t stray too far from the underlying index, limiting the “beta.”

The result will be a new formula, one which automatically selects assets that meet its criteria. The fund will not be managed based on evolving judgment calls. Instead it is a passive system. Based on the formula, the fund will add and remove assets that meet its criteria on an ongoing basis.

Smart Beta Looks for Many Criteria

Here's everything you need to know about smart beta investing.Finally, it’s important to look carefully before buying a smart beta fund. All of them share the same goal of combining the stability of an index with the potentially higher returns of an actively managed fund. However they do so in different ways. Specifically how the fund builds its smart trading criteria is important.

Different funds look for different qualifications in assets. Some will prioritize growth while others look for age or trading volume. Some funds will prioritize assets with high dividends, while others might look for low-volatility above all.

The Bottom Line

Smart beta builds index funds that attempt to outperform their target index. With any luck, the majority of assets track the index while other perform slightly better than the index overall.

Smart beta funds can often produce strong returns. Just make sure that you agree with the strategy your fund has taken before investing.

Risk Tips

  • If you aren’t sure what your risk tolerance for investment is, consider talking to a financial advisor. Finding the right financial advisor that fits your needs doesn’t have to be hard. SmartAsset’s free tool matches you with financial advisors in your area in 5 minutes. If you’re ready to be matched with local advisors that will help you achieve your financial goals, get started now.
  • ETF’s may seem like mutual funds, but they’re not. Read more to learn which one might be the right asset for your trading strategy.
  • Volatility is all about risk. Get that right and you’ll be on your way to mastering your own portfolio. And the first step is understanding tail risk.

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Eric Reed Eric Reed is a freelance journalist who specializes in economics, policy and global issues, with substantial coverage of finance and personal finance. He has contributed to outlets including The Street, CNBC, Glassdoor and Consumer Reports. Eric’s work focuses on the human impact of abstract issues, emphasizing analytical journalism that helps readers more fully understand their world and their money. He has reported from more than a dozen countries, with datelines that include Sao Paolo, Brazil; Phnom Penh, Cambodia; and Athens, Greece. A former attorney, before becoming a journalist Eric worked in securities litigation and white collar criminal defense with a pro bono specialty in human trafficking issues. He graduated from the University of Michigan Law School and can be found any given Saturday in the fall cheering on his Wolverines.
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