Smart Beta

In my previous post, I showed that Beta is a measure of volatility.  I also showed that Beta is pertinent to individual stocks because Beta shows the stock’s volatility relative to a benchmark index, and that Beta is not as pertinent to ETFs or mutual funds.  So now you have a number of new (in the last 5-6 years) fund strategies that call themselves “Smart Beta” funds.  If Beta isn’t pertinent to funds, then is “Smart Beta” either just nonsense or a marketing gimmick by the fund managers?  Well, no, there is a valid concept behind Smart Beta funds, and it may be something you should investigate, especially if you are risk-averse.

Low Volatility

The most prominent Smart Beta ETF’s are PowerShares S&P 500 Low Volatility (Ticker:  SPLV) and IShares MSCI Min Vol (USMV).  Combined, these 2 ETF’s had over $20 billion of assets as of 6/30/17 (Source:  Investopedia).  Both of these funds try to minimize volatility while preserving upside and while still calling themselves index funds.  SPLV mirrors the S&P 500 Low Volatility Index, which is an actual Standard & Poor’s Index.  The Low Volatility Index uses the S&P 500 as its universe of possible stocks to invest in, but limits its “holdings” to the 100 lowest-Beta stocks, and re-balances its “holdings” each quarter.


These low-vol Smart Beta funds appeal to investors’ risk-aversion.  The meme or narrative goes something like this:  Index investing is trendy, and investors (and investment managers for that matter) want to follow the trends and keep expenses low by investing in index funds, but at the same time they don’t like the drawdowns they get with the S&P 500 Index (See: 2008), so they can have their cake and eat it too by investing in a low-volatility index.  In his newest book, “The Undoing Project”, Michael Lewis (Author also of “MoneyBall” and “The Blind Side”) shows that the subjects of his book, economics/psychology professors Amos Tversky and Danny Kahneman demonstrated that Fear is a much greater human motivating factor than is Greed.  Investors are happy to earn more on their investments, but once they have their money, they really don’t want to lose it.  Likewise, investors typically overestimate their “loss threshold” – the amount of loss they can sustain in their portfolio and still be okay with it.  “Wow, I thought I would be okay if I lost 20%, but now that my portfolio is down 5%, I am freaking out!!”  Low-volatility Smart Beta seeks to calm investor fears about drawdowns.

Do They Work?

Yes – so far.  SPLV and USMV have been available to shareholders since 2011.  According to its Product Detail website page, during the 10 worst-down calendar months since its inception, SPLV has mitigated 43% of the S&P 500 Index losses during those months.  Since its inception, SPLV is slightly outperformed the S&P 500 Index, but in the past calendar 12 months (ending 6/30/17), the S&P 500 Index has more than doubled the low-vol index.  Why is this?  The FANG stocks.  The past 12 months has been very favorable to high-Beta investing, including the large cap high-techs such as Facebook, Apple, Netflix and Google.  Low-vol ETF’s won’t be holding FANG stocks.  USMV also claims to have outperformed the S&P 500 Index since its inception, but not in the last 12 months.


The two main criticisms of Smart Beta, particularly low-volatility strategies, are 1) by definition they limit their investments in growth companies because growth companies have higher Betas; and 2) low-volatility strategies will become overpriced as more money flows into them.  #1 is true, and therefore investors are largely in boring, low-growth, high cash flow companies.  I know of an investor in Omaha who follows the same script.  As for #2, there is a long way to go before these strategies start tilting the market – they are still a blip relative to the larger indexes.  That said, don’t overpay.


Investing in a strategy that is a twist on an Index is nothing new.  The “Dogs of the Dow” strategy has been around for many years.  That strategy invests in the 5 highest-yielding Dow 30 stocks and rebalances every year on the first trading day of the year.  We have not had a true Bear Market (down 20% or more) since 2011 so we don’t really know how these strategies will perform in a Bear Market.  On paper, a low-vol strategy should be somewhat safer, but not completely safe.  They are more applicable to an older investor whose goal is capital preservation.

I have focused on low volatility Smart Beta strategies in this post.  There are other Smart Beta strategies to examine in future blog posts.  Stay tuned!