Analysis: Are ‘Smart Beta’ Index Funds Suitable for You?

Some investors and financial advisors have recently migrated to a species of index funds with unique characteristics — smart-beta funds.

These funds seek to enhance returns with a view toward outperforming the market rather than simply tracking an index. Investors have been pouring money into smart-beta funds. According to the investment research firm Morningstar, as of August 31, 2019, there were $1.07 trillion in assets under management in smart beta funds, up from $690 billion at the end of 2016.

Smart beta funds, also marketed as strategic-beta or factor funds, track indexes in the same manner as a traditional passive index or ETF fund. However, instead of weighting the holdings in the specific benchmark index by market capitalization, smart beta funds select individual stocks with certain characteristics or “factors” that can ostensibly lower market risk or outperform the market as a whole.

Some of the factors for inclusion may include measures such as price/book value, earnings growth rate, and historical price/earnings ratios, as well as variation or deviation from the market as a whole during periods of turbulence.

Investors should be mindful, that although they are characterized as passive investments, smart beta funds differ from true index funds because their operation requires the intervention of an investment advisor.

Each smart beta fund manager makes the initial decisions about which factors or financial measures will determine inclusion into the fund. This requires an exercise of discretion or individual judgment by the investment manager.

By comparison, most index-style ETFs are automated and require only limited involvement by the fund manager. Purely passive funds simply mimic their designated index, such as the S&P 500, with only modest formulaic adjustments to the fund based on the shifting market capitalization of individual stocks that comprise the index.

Investors should be aware that even though the factors upon which the funds are created are selected by quantitative analysis and research, the smart beta fund manager determines which individual stocks or assets comprise the custom-made strategic beta index.

Thus, two comparable smart beta funds may have similar investment objectives or common “factors” between them but their performance could differ dramatically.


Smart beta funds can be used as an integral component of your overall investment portfolio. These funds should be selected based on your particular investment objectives, your age and your risk tolerance.

For purposes of determining a suitable strategy in accordance with your risk aversion, it should be noted that different factor funds may outperform or underperform the market at certain periods of time or based on particular market environments.

For example, despite their lackluster performance over the past decade, “value” smart beta funds, which focus on shares of companies that are selling far below their intrinsic value, recently outperformed “momentum” funds dramatically.

An investor with a value-based factor fund would have profited from this recent upward movement in underpriced value stocks relative to pure momentum factor funds.

Momentum stocks, such as Netflix, Facebook and Amazon, have led the market surge during the past several years and have consistently outperformed the overall S&P 500 index. Momentum funds could be an appropriate addition to an investor’s overall portfolio and help to diversify risk. These funds seek to purchase the high-performing stocks with the most outsized performance record relative to the market as a whole.

Even though the valuation of many momentum stocks may seem inordinately high, fund managers continue to purchase these shares in the hopes that they can be sold at an even higher price at a future date. As evidenced by the unfettered upwards trajectory of the tech stock group, regardless of their ever-increasing share prices, investors with momentum factor funds have realized generous returns.


Even though some particular beta funds may currently be generating high returns it is prudent for investors to diversify their holdings among a diverse group of smart beta funds. A disproportionate weighting in one specific fund entails considerable risk over the long-term. This is because during any market cycle particular factors will fall out of favor and generate losses instead of gains.

One potential strategy would be to select both a momentum and value smart beta fund as well as a low volatility factor fund. A portfolio constructed in this manner could help improve your overall returns and limit risk as the portfolio wouldn’t be impacted by factors that decline in unique market environments.

Carefully selecting appropriate smart beta funds could act as a hedge to cushion other components of your portfolio that may be more sensitive to short-term market downturns or swings in the market. For example, an investor might own a low-volatility smart beta fund that would offset some of the short-term losses incurred from stocks whose price drops during market declines or selloffs.

Although fees for smart-beta funds are generally higher than unvarnished index funds, their costs relative to actively managed funds is still low.

Expense ratios on factor ETFs average approximately 0.17%, according to a Morningstar report. This is slightly higher than a typical ETF tied to a cap-weighted index such as the S&P 500 but still substantially lower than a typical actively managed mutual fund.

Investors should be aware that because of their stated investment goals some smart beta funds may trade more frequently than other strategic beta funds and this will increase overall costs and fees.


Smart beta funds can provide much needed psychological comfort for investors who react adversely to short-term market vacillations and may be prone to making impulsive investment decisions.

Investors need to be mindful that factor funds are a long-term investment. As noted above, certain investment attributes may fall out of favor during certain unpredictable periods in the overall market cycle. This could have a detrimental impact on that particular fund within your portfolio. However, research has demonstrated that consistent favorable investment performance is predicated on long-term holding of stocks and of smart beta funds.

Investors who lack the discipline to endure short-term declines should not purchase strategic beta funds, as their instinct will always lead to panic selling during market downturns, which can diminish their overall long-term investment rate of return.

In order to determine whether smart beta funds might be an appropriate investment vehicle and complement your existing portfolio, scrutinize each smart beta fund’s prospectus. Carefully consider the unique investment philosophy and structure of each fund, its associated fees and whether it fits within your overall investment objectives.

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