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Untangling the Lingo: Alpha, Beta, and Smart Beta

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A great deal of the ETF marketing material that crosses our desks takes it for granted that an ETF investor is familiar with—and understands the difference between—alpha, beta, and smart beta. However, if recent financial literacy surveys are any indication, there is a vast gulf that separates ETF issuers from the average ETF investor, even a financially savvy one.

So, with the goal in mind of clearing the air, we thought we would take a crack at untangling some of the trickiest terms that we find ETF issuers struggling to put into simple language for their investors.

Related: Cut to the Chase: Your ETF’s Message Should be Simple, Even if the Fund is Complex

Related: ETFs Versus Mutual Funds: What’s the Difference?

Beta

In its narrowest possible definition in the financial world, beta refers to the volatility of a given security or portfolio in relation to the overall market (usually defined as a broad index such as the S&P 500). Although the math involved in calculating a security’s beta can be complex (and is beyond the scope of this explanation) the result is a number, greater or less than 1. By definition, the broad market has a beta of 1.0. A number higher than 1 indicates higher volatility and greater price swings than the overall market, while a number less than 1 describes a less-volatile security. If a portfolio or security has a beta of 0 or below, it is assumed to be uncorrelated to the market.

But what does all this math have to do with ETFs? Since the broad market has a beta of 1, the word “beta” has come to serve in the ETF world as a shorthand for “market exposure” or “passive investing.” The vast majority of ETFs seek to passively track an index. And since indexes are simply measures of different slices of the market, the goal of many passive index ETFs is to provide investors with “beta” or market exposure.

In practice, what this “market exposure” ends up looking like in each individual ETF can vary quite substantially. For example, a passive index ETF that tracks a subsector such as Blockchain or Biotechnology may be substantially more volatile than an ETF that passively tracks Utilities. However, it is the concept of “beta as market exposure” that has given rise to the marketing buzzword that has perplexed investors and furrowed the brows of many ETF marketers: smart beta.

Smart Beta

As investment professionals are fond of saying, there’s more than one way to skin a cat. Likewise, there is more than one way to construct an index. Even though index-tracking ETFs are passive investment vehicles, the rules by which the index is constructed have a tremendous effect on an ETF’s performance.

Smart Beta ETFs track indexes that utilize a number of different approaches to index construction. Usually, these alternative indexing approaches utilize factors beyond market capitalization—a company’s public valuation—to select and weight securities differently. These factors could include quality, momentum, value, low volatility, or a combination of multiple factors. The result is a passive investment vehicle that is optimized to provide improved performance for investors. In the best-case scenario, a smart beta ETF could provide above-market returns (alpha, which we’ll get to in the next section), with only broad market levels of risk (beta).

Whether smart beta is actually smart depends very much on the individual ETF and the investor in question, which is what distinguishes the marketing phrase “smart beta” from the more rigorous financial theory of “beta.”

Alpha

This leaves alpha. Simply put, alpha is the performance of an active investment measured against a benchmark. In the investing world, alpha is also often used as a shorthand for “excess return” or “investment outperformance.” There are an increasing number of ETFs that seek to deliver alpha. In contrast with more traditional passively-managed ETFs, funds that seek to deliver alpha are actively-managed. This means that, rather than tracking an index, the fund managers are selecting securities on an active basis in an attempt to outperform the ETF’s benchmark.

Conclusion

By taking a closer look at beta, smart beta, and alpha, investors can gain a deeper understanding of what these phrases mean with regard to specific ETFs, which places them in a better position to make investment decisions in the future.

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