In a previous blog, we covered the differences between active and passive investing. Today, we will introduce you to their product: smart beta investing, otherwise known as factor-based investing. This approach has gained much attention recently due to its combination of the advantages from both active and passive investment styles.

Before we start, let’s define factors. Factors are any element or influence which could potentially help you generate higher portfolio returns. These could be related to the macroeconomy (eg. inflation or GDP), to the firm (eg. liquidity or stock price volatility), or to styles (eg growth or value). By increasing or decreasing a portfolio’s exposure to certain factors, an investor can improve the portfolio’s diversification or tilt it toward favourable aspects. Empirically, positive exposures to factors such as small-cap stocks, quality stocks, value stocks (low P/B ratio), stocks with low volatility, or stocks that have performed well in the recent past have been found to deliver strong returns moving forward.

Now, let’s link this to smart beta. Compared to traditional approaches, a smart beta strategy is a blend of active and passive investing. Similar to a passive portfolio, a smart beta strategy is rules-based, low cost and transparent. However, it also contains active elements. A smart beta fund could aim to enhance returns or mitigate risks by capturing factor exposures which deliver strong performance not available from a pure passive approach.

Alongside the increasing popularity of smart beta is the attention placed on smart beta ETFs. These adopt a rules-based approach to following a particular index, but also consider alternative factors when choosing particular stocks from the index to hold. Certain ETFs may only hold stocks in a particular industry or sector, stocks that exhibit a certain characteristic, or stocks of a certain size. Hence, smart beta ETFs can help improve risk-adjusted returns, though they are still riskier than passive ETFs.

Disclaimer: The intent of this blog is to provide careers advice, not financial advice. It does not take into account individual circumstances. For financial advice, please see a financial adviser.