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Smart Beta strategy has gained popularity in last years in fact its utilization has been in an upward growth trend. Therefore, Smart Beta indexes have become a relatively inexpensive tool that ensures diversification and at the same time helps to capture excess returns on investments.

Traditionally, passive portfolios are structured using an easy to implement market capitalization method, which means that a company is chosen based on its share price multiplied by the number of outstanding shares. With Smart Beta the main idea is to use index-based strategies that choose or weigh securities by using any other factor than their market capitalization. Why? The market-cap approach is still widely used as it is attractive and inexpensive to implement. However, as it weighs companies based on price and number of shares issued, it carries a risk of giving more exposure to over-priced, and less for under-priced stocks. Also, it underestimates the promising potential of smaller firms and gives preference to those that have already experienced growth in the past. Smart Beta strategy breaks the link between price and portfolio weight, relying on alternative measures when selecting a weighting method such as volatility, liquidity, quality, value, profitability, size or momentum. This means that Smart Beta considers granular factors that are specific to a particular company or industry. In fact, these funds don’t track standard indexes, such as the S&P 500 or the Nasdaq 100 Index, but instead, focus on areas of the market that offer an opportunity for exploitation.

Smart Beta is the middle ground between passive and active investing because like the passive management, it is a low-cost approach that offers lower risk through diversification and has a clear investment process. On the other hand, this strategy aims to outperform the market, which is an essential characteristic of active investing, but at a reduced cost compared to active management. Thus, Smart Beta is considered as an intersection of passive and active investing as it combines principles of both techniques with the goal to construct an optimally diversified portfolio at a cost lower than traditional active management and marginally higher than straight index investing.

What about risks associated with Smart Beta?

The strategy represents still a relatively new method of investing and can exhibit low trading volumes. Low trading volume means low liquidity which can result in investors not being able to sell or exit their positions easily.

Trading costs can be high to re-establish the original index weighting. As a result, the fees charged for Smart Beta might be lower than actively managed funds, but the savings might not be significant because some Smart Beta funds can be expensive since stocks have to be bought and sold to meet the fund's rules.

Smart Beta funds can underperform traditional passive indexes, such as the S&P 500 since they need to be constantly readjusted to the indexes. In other words, holdings are added and sold based on the rules of the fund and this can lead to underperformance.

Since Smart Beta funds have so many variables to consider, trading them can be more difficult than trading with traditional passive indexes. As a result, the prices of Smart Beta funds can vary from the fund's underlying value.

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Autore: Beatrisa Pucalev, Asset Management, Risk Junior Associate

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