Tom Dorsey, Co-Founder of Dorsey, Wright & Associates, a Nasdaq company, is a pioneer in smart beta investing. For those who’ve never heard that term before, smart beta is an investment strategy that attempts to deliver better risk/reward outcomes than your average, diversified, market cap-weighted index. Portfolio managers do this by building a fund of securities using weighting schemes based on volatility and other factors, like dividend yield. Instead of matching their fund to the index weightings, they create rules based on time-tested factors that may have better upside potential. More than simply tweaking weightings, it’s an entirely alternative way of constructing a fund or ETF.
Dorsey created a number of smart beta funds at Arrow Funds, First Trust, Powershares, Principal Funds and others. Now he’s tossing out a new lexicon into the financial world: smart indexing.
“Most people think of indexing as just buying ETFs based on the Standard & Poor’s 500 index. What’s so smart about that? But the equal-weighted S&P 500 has beaten the cap-weighted S&P 500 index…most advisors do not know that,” Dorsey says.
Who knew there were two? Smart indexers will compare factors and index components with the capitalization weighted version when constructing a portfolio. To do that on their own, they need to conduct a relative strength calculation to construct a portfolio. If they did that on all the underlying stocks in the S&P 500, it would take a small army of analysts. Today’s financial technology allows investment firms to do that more easily.
There are now so many different types of indexes out there that investors really don’t need to step outside of the fence of indexing to outperform the market.
Of course on the core indexing side, market capitalization indices are gathering the most assets. Investors who believe it’s possible to beat the market will choose active investment funds, or go the route of diversifying into these new smart index funds that blur the lines by putting active bets into the index construct. Over the last two years, several new products have popped up with this strategy in mind.
Smart beta was a very smart marketing tool for years, Dorsey says. It means anything other than cap weighted benchmarking. “To me it means if you have a rules based approach, its smart beta. Smart beta means you can use all different types of sectors in your mix,” he says.
Smart indexing, meanwhile, is a bit different. Learn more: Watch the WEBCAST On Demand.