Getting smart on smart beta

Smart beta is a strategy increasingly evaluated in today’s investment landscape. At times coined “alternative beta,” “strategic beta” or “intelligent beta,” the investment approach is still a relatively new phenomenon for investors and one that many are still trying to understand. Despite their limited history, smart beta solutions increasingly are finding their way into investors’ portfolios. As smart beta continues to gain momentum, particularly in the institutional market, now is the time for investors to get smart on smart beta.

In the simplest terms, smart beta is founded on alternative weighting methodologies such as low volatility, high-dividend, fundamentally weighted, equal weight, high beta and enhanced fixed-income funds. Smart beta exchange-traded funds track indexes based on these alternative weighting methods, which in the past have delivered favorable risk-adjusted returns and varying returns across different market regimes. Today, there are more than 350 smart beta ETFs available in the U.S. holding more than $230 billion in assets under management — a number that is rapidly growing.

According to a new study, "The Evolution of Smart Beta," conducted by Invesco PowerShares and Market Strategies International, more than one-third of institutional investors that are using ETFs are now also using smart beta ETFs, up 24% from last year. Additionally, smart beta ETFs saw the highest year-over-year increase in institutional usage from 2013 to 2014.

The study highlights that the investment strategy is also standing on the success of a larger ETF revolution, where investors added more than $240 billion to U.S.-listed ETFs in 2014 alone, bringing the overall AUM to nearly $2 trillion.

Smart beta ETFs should become progressively more attractive in the current market environment. As the Federal Reserve weighs a potential rate hike and many anticipate an oncoming bubble burst, Wall Street experts are widely in agreement that the market is due for a major correction. As such, investors can use smart beta ETFs tied to low volatility indexes. For example, the PowerShares S&P 500 Low Volatility Portfolio is based on a subset of stocks from the S&P 500 with the lowest realized volatility over a 12-month period.

By incorporating low-volatility ETFs into their portfolios, investors are able to remain invested in equities while increasing their potential for downside protection. Maintaining some equity exposure, even during market corrections, can be important over the long-term to protect against inflation and potentially result in future purchasing power. While volatility is merely one factor addressed through the adoption of smart beta ETFs, it is at the forefront of investors’ decision-making, particularly those who suffered through more volatile market conditions in the not-too-distant past. For investors with greater concern about market volatility and an impending downturn, new smart beta ETFs can even offer full hedging capabilities.

Smart beta ETFs offer a versatile, transparent way to meet investors’ objectives outside of managing volatility. The strategy is often commended for its managing performance, access to specific markets / sectors, portfolio completion, and some have the ability to make tactical adjustments to asset allocation strategies. The investment vehicle is also known for its low cost fees, with many institutional decision makers turning to ETFs as a means of reducing expenses.

Investors have a wide array of choices when it comes to the smart beta ETF universe. This plethora of choices can be daunting for many portfolio managers, financial advisors and investors. In fact, the majority of institutional decision makers who have not started using smart beta ETFs explain their hesitation as a lack of familiarity with the funds. However, research surveys suggest that familiarity is growing steadily. According to the recent PowerShares study, nearly two-thirds of institutions indicated in a recent study that they would increase their use of ETFs over the next three years — and within that, they plan to utilize smart beta versions most. The challenge now is for the ETF industry to ensure investors understand the options available to them and recognize the many ways they can be incorporated to help them reach their investment goals.

Dan Draper is managing director of global ETFs for Invesco PowerShares Capital Management LLC.