I don’t know a lot about set theory, but I have read Gödel, Escher, Bach, so it totally makes sense that there could be more sets of stocks than there are actual stocks.
The number of market indexes now exceeds the number of U.S. stocks. Traditional ones such as the S&P 500 are collections of securities weighted by market value, and index funds mimic them as a low-cost way to deliver the market’s performance. Many new indexes are different: They include stocks based on custom criteria, such as having low volatility or high dividends.
But how did we create these new stock groupings, which always existed mathematically but had to be defined and labeled by humans and/or computers? They’re called “smart-beta ETFs,” and the process by which they are created is fascinating:
“Beta” measures the volatility of an individual security/portfolio, as compared to the broader, whole securities market. The stock market, which often uses the S&P 500 index as its proxy, has a beta of one. Individual stocks are then ranked according to how much they deviate from that beta.
A stock with a beta of two has a return that, generally, changes by twice the magnitude of the overall market’s returns — whether returns are positive or negative. “Smart” refers to the use of an alternative methodology rather than following an index’s size-based (market-cap) allocations.
A smart beta investment strategy is designed to add value by strategically choosing, weighting and rebalancing the companies built into an index based upon objective factors.
This is where I’m going to to say “just read the whole CNBC piece,” because it would be inappropriate to quote all of the details here. But seriously. Smart-beta ETFs are passively managed ETFs that rebalance themselves. They’ve been around since 2003, so it’s not like they’re brand-new things, but it’s clear they’re becoming more popular.
What does Bloomberg think of these ETFs?
Smart-beta ETFs are generally more expensive than S&P 500 funds but cheaper than actively managed funds. It remains to be seen how well the new funds will perform.