Charles H. Sloan Discusses the Rise of Smart Beta ETFs
A stock index is a way to measure the performance of a group of stocks, providing investors with a snapshot of how the overall market or specific sectors are doing. Even before the development of Modern Portfolio Theory (MPT), stock indices were already in use to track market trends. Over time, they have become the go-to for many investors seeking a diversified portfolio. MPT suggests that owning a broad market portfolio will allow investors to match the expected return with the risk-free rate, as the entire market grows along with the economy.
The primary advantage of stock indices, especially in the form of Exchange Traded Funds (ETFs), is risk diversification. By investing in an index, investors can spread their risk across many stocks, reducing the impact of any one stock's performance. However, this comes with a trade-off. Investors lose the ability to actively select individual companies or sectors to invest in, which can make index investing feel passive.
That said, index investing doesn't have to be passive. While it traditionally involves buying and holding a broad set of stocks, newer strategies such as Smart Beta ETFs have emerged. These ETFs use risk factors like value, growth, and momentum to build portfolios designed to outperform traditional market-cap-weighted indices. In these cases, index investing may no longer be entirely passive, as it involves more active decisions in selecting the factors that shape the index.
Currently, global ETFs are valued at over $5 trillion, and investment firms continue to innovate with new products targeting specific market segments. While some investors believe index funds offer a hands-off approach to investing, others argue they can contribute to a focus on short-term performance metrics rather than long-term company fundamentals.
Should you rely on index funds? While they are a good choice for investors without the time or knowledge to research individual stocks, pure index investing may lead to an overemphasis on performance ratios rather than business operations. For those who prefer a more traditional approach, combining a balanced stock-bond portfolio for the long term may be the best strategy.