Wednesday, April 22, 2015

Smart Beta

Beta, in the investing universe, is a measure of risk relative to a chosen benchmark. For example, if a stock has a beta of 1 vs. the S&P 500, it should move just as far up (or down) as the index itself does. The definition and calculation of investment indices have numerous components (see our previous discussion in Investment Strategies). The S&P 500 stock index is composed of the 500 largest companies (as defined by their market capitalization) in the US. The company’s market capitalization is determined by multiplying the number of corporate shares outstanding times the price of the stock. That calculation results in a relative concentration of large companies. In fact, the top 10 companies in the index (2% of the 500 companies) comprise approximately 17% of the index.

In April, 2005, a group of researchers (Rob Arnott, Jason Hsu, and Philip Moore) posited in the Financial Analysts Journal that there were better measures of a company than its market capitalization. They claimed to “show that the fundamentals weighted, non-capitalization based indexes consistently provide higher returns and lower risks than the traditional cap-weighted equity market indexes while retaining many of the benefits of traditional indexing.” They felt that measures such as revenues, book value, sales, dividends, cash flow, etc. should be better measures used in valuing a company. The basic intent was to decouple the price of a stock with its weight in an investment portfolio. That coupling, according to them, results in excessive holdings of large cap stocks in the funds that track a capitalization weighted index.

This fundamental weighting has led to a significant number of new “smart beta” or fundamental weighted mutual funds or exchange traded funds (ETFs). Some strategies are return oriented seeking to increase returns over a standard benchmark by using company revenue, earnings, momentum, size, etc. Other strategies seek to modify the risk level vs. the benchmark by employing other strategies.

There is significant disagreement among financial professionals about the usefulness of such strategies. In fact, are they truly “indexing” or another form of active management? Smart beta has generated a lot of interest in terms of new funds and ETFs; however are they sound investment principles or “marketing hype?” There are proponents on each side of the argument. The jury is still out on the final decision.

Smart beta investments usually charge a higher expense ratio than standard indexing investments; the investment methodology is usually more complex. That fee is in the 25-40 basis point range.

We, at Paragon Financial Advisors, believe you should invest in those things which you understand—and which lead to the attainment of your financial goals at your accepted risk level. We’ll be glad to discuss your investment options with you.  Paragon Financial Advisors is a fee-only registered investment advisory company located in College Station, Texas. We offer financial planning and investment management.

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