How to benchmark smart beta

We know how to evaluate core funds against an index. Now, let’s see how to set benchmarks for smart beta funds.

Fall is here, which means I finally get to sleep in on Saturday mornings, instead of going to my eight-year old’s weekly swim meets. My daughter wasn’t the biggest fan of the 8 a.m. meets and grueling practice sessions, but this summer I saw a lot of progress. Her speed improved lap over lap, her strokes became more refined and forceful, and her enthusiasm for swimming grew. During the summer, we both grew to love her participation on the swim team. Some parents measure success by whether their kid can beat every swimmer of every age in the pool, but in my perspective, this personal improvement is what points to a successful season!

This family triumph relates to a question that I often get asked: How can investors track the success of smart beta funds?

Benchmark by smart beta goals

We use benchmarks as a way to evaluate the performance of funds and managers. If the investment strategy is tied to a particular asset class, it’s simple to pick a benchmark index. But how do you pick a benchmark for smart beta funds? Well, that depends on the outcome you are seeking.

Smart beta funds are powered by investment factors, which are broad and historically persistent drivers of return. I suggest you set benchmarks for your smart beta funds based on your investment objective for each strategy. Investors tend to have three major goals for smart beta funds: enhancing returns, filling style box allocations and reducing risk. Let’s look at each goal to find the most appropriate fund benchmark.

Goal 1. Higher returns

Investors seeking above-market returns while maintaining a similar level of market risk may want to consider single-factor strategies—such as value, quality, momentum and size funds—as well as multifactor strategies that combine multiple factors into a single fund.

Because these strategies can provide enhanced returns while maintaining a similar level of  risk as a broad market index, an appropriate benchmark for them is that same broad, market capitalization-weighted index. This could be a U.S. index or an international one, depending on the investment universe you are trying to capture.

Goal 2. Style box complement

I recently wrote about using smart beta ETFs to refresh holdings in the Morningstar style box, noting that investors can consider swapping out growth for momentum, upgrade blend to quality and deepen traditional value with smart beta value.

These strategies could be used to balance a portfolio or express short-term tilts, so an appropriate benchmark for them is a traditional style index—using a growth index for momentum ETFs, a broad market index for quality ETFs and a value index for (you guessed it) value ETFs.

Goal 3. Reduced risk

Investors who buy a minimum volatility fund may be looking to harness the power of factors to seek less risk while maintaining market exposure.

It’s true that the goal is reduced risk, but we also care about how much return we get for that amount of risk, or risk-adjusted return. For investors who don’t find it intuitive to measure success by the Sharpe Ratio, an easy way to think about success for minimum volatility funds is whether you’re getting market-like returns and exposures with less risk. Therefore, to evaluate minimum volatility funds, we can compare their volatility to the volatility of a broad market index.

In summary

My promising swimmer achieved the goals I set for her by growing more enthusiastic about diving into a cold pool early in the morning. Other families may work toward different goals. Similarly, smart beta strategies target different goals than core market exposures.

Whether you’re seeking enhanced returns, style box exposure or reduced risk, select a benchmark that appropriately measures your fund’s ability to deliver on those goals.

Use the suggestions in the table below to get started.


Sara Shores is the Head of Strategy for BlackRock’s Factor-Based Investments and a regular contributor to The Blog.

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There can be no assurance that performance will be enhanced or risk will be reduced for funds that seek to provide exposure to certain quantitative investment characteristics (“factors”). Exposure to such investment factors may detract from performance in some market environments, perhaps for extended periods. In such circumstances, a fund may seek to maintain exposure to the targeted investment factors and not adjust to target different factors, which could result in losses. The iShares Minimum Volatility ETFs may experience more than minimum volatility as there is no guarantee that the underlying index’s strategy of seeking to lower volatility will be successful.

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