Smart beta is an alternate trading strategy that has been an integral element of ETF trading.
As part of trading education, there are some technical terms you need to grasp to be able to analyze successful investing and stock trading. Smart Beta being one such term.
Beta is a technical term in investing, and Investopedia defines it as the level of risk an investor faces when he/she holds a particular portfolio or stock in comparison to the whole market.
Why Is Smart Beta so Smart?
According to the Financial Times Lexicon, smart beta refers to investment strategies that apply alternative strategies of index construction to conventional indices that are based on market capitalization. Smart beta aims at getting better returns through lower costs, and this helps when there is a fair amount of volatility in the market and the economic climate is uncertain. These are rules-based strategies and therefore don’t rely on conventional weights of market capitalization since the latter is known for overweighting stocks that are overvalued and underweighting stocks that are undervalued, which results in insufficient returns. Smart beta seeks to provide a better balance of risk and return thanks to its alternative weighting strategies that are based on dividends and volatility.
Smart beta is now a very important element of ETF trading. ETF users have begun wondering if this alternative weighting strategy could spread to the fixed income arena. Equity funds currently dominate the smart beta universe. As these smart equity funds are welcomed by more investors and advisors, there could be increasing demand for bond funds that are alternatively weighted.
Drawbacks of Conventional Bond Funds
Conventional bond funds seem to have the same disadvantages as the equity ETFs that are cap-weighted – disadvantages such as depending on the biggest securities rather than the best as the primary return drivers. This strategy keeps them from being diverse and gives them limited exposure to securities that could yield higher. Investopedia quotes the example of standard aggregate bond ETFs that usually get allocated too much to mortgage-backed securities (MBS) and US Treasuries, keeping them from corporate securities that yield higher.
Investopedia also points out that some of the legacy corporate bond ETFs weigh the components by value of issue outstanding or size of issue. But there could be more income and possibly lower risk when corporate bonds are gauged with alternative weighting techniques.
Smart Beta Bond ETFs
ETF users have been craving for smart beta bond ETFs. There are legacy products in this category such as the PowerShares Emerging Markets Sovereign Debt Portfolio ($PCY), which is the 2nd largest bond ETF in the emerging markets category. More than 10 years old, it has assets worth nearly $5 billion under management. It employs a proprietary index methodology for providing exposure to the developing world sovereign debt. That makes the ETF look different to the conventional emerging markets bond funds.
With more than $1.2 billion in terms of assets under management, the PowerShares Fundamental High Yield Corporate Bond Portfolio ($PHB) tracks the RAFI Bonds US High Yield 1-10 Index. $PHB will soon be 10 years old.
When you see the overall picture though, you had just 40 bond ETFs in the second quarter in the United States that truly met the criteria for smart beta. Of these, only the aforementioned $PCY and $PHB plus another ETF had assets exceeding $1 billion.
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