Lesson type: Understanding diversification

Can you outsmart smart beta?

Don't be put off by the name - while terms like "smart beta" and "factor investing" may seem impenetrable at first, they're actually becoming an important part of diversifying certain investment portfolios.

Put simply, a smart beta approach (which is usually accessed through an exchange-traded fund, or ETF, which you can purchase like a stock) is designed to improve risk-adjusted returns from a particular index of stocks – let's say the top 200 companies on the ASX - using different "weights".

An example

Let's say, for example, you've invested $10,000 in the S&P/ASX 200 via an index fund: in this case, your money will be invested proportionally to the "size" of that stock in the index, so that more of that $10,000 will be invested in the Commonwealth Bank than BHP, then Westpac and so on.

Using a particular example of a smart beta approach, though, you could invest that $10,000 equally across all stocks included in the index. But why would you do this? Well, some have argued that the traditional "size" metric - also known as market capitalisation - inherently favours bigger (and potentially overvalued) companies while missing out on growth opportunities from smaller companies.

It stands to reason, after all, that a smaller company has the potential to grow in size at a faster rate than the largest bank in the country.

Furthermore, investors can become exposed to what's known as "concentration risk," where the majority of their money is invested into a relatively small selection of companies - and in the case of the ASX, the majority of those will be banks, which tend to go up and down at a similar rate.

By spreading that investment equally across all stocks in the index, though, you can both mitigate concentration risk while also exposing yourself to growth from the smaller players.

Other factors

But applying an "equal weight" to an index is just the tip of the smart beta iceberg.

The smart beta approach involves what's using "factors," which are defined by global investment manager BlackRock as being "the foundation of portfolios — the broad, persistent forces that have driven returns of stocks, bonds and other assets."

Factors can include "momentum," which prioritises companies with upward price trends; "minimum volatility," which focuses on stable, lower-risk companies; and "value," which targets companies that appear to be trading at a discount relative to their underlying business characteristics.

By applying a "value" slant to the ASX 200, for example, you would be investing more money in said discounted companies, and less in those that appear to be trading at "fair value" - or those that appear to be too expensive.

Risks to consider

It's important to note, though, that specific "factors" tend to perform well in particular market cycles - and, in some cases, in different regions as well. A minimum volatility approach might enable you to weather market downturns, but you may miss out on the upside in the process.

As always, your best bet is to ask your financial adviser whether this kind of strategy would work for you.


The opinions expressed in this content are those of the author shown, and do not necessarily represent those of No More Practice or its related entities. All content is intended for a professional financial adviser audience only and does not constitute financial advice. To view our full terms and conditions, click here.

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