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Factor-Based Investing

Traditional indexes such as the S&P 500 are weighted based on market capitalization, the value of a company's total outstanding stock. This means the largest companies in the index may have a much greater influence on index performance than smaller companies. For example, the 10 largest companies in the S&P 500 account for more than 18% of the index's performance, as opposed to about 2% if every company were weighted equally.1

Funds that track market-weighted indexes may be the most direct and efficient way to participate in broad market performance, but there has been increasing interest in an alternative indexing strategy called smart beta (also called strategic beta or factor-based investing). A 2015 survey found more than 450 smart-beta funds trading on U.S. markets, and many more were launched in 2016.2-3

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Shifting the Weight

Smart-beta mutual funds and exchange-traded funds (ETFs) use clearly defined factors other than market capitalization to select and weight investments in order to track an existing factor-based index or create a new index. Some factors that might be considered are momentum, risk, volatility, growth potential, price-to-book value, dividend growth or yield, earnings, cash flow, or equal weighting of all securities. (Traditionally, beta is a measure of an investment's volatility against the market, but smart-beta indexes may or may not consider volatility.)

A Long-Term Strategy

An industry study found that certain smart-beta strategies outperformed the broader market over five different market cycles from December 1991 through June 2015.4 (A market cycle is a period from one peak to the next peak, or from one trough to the next trough.) However, the specific strategy that was most successful varied from one cycle to the next. This is one of the fundamental challenges not only of smart beta but of any strategy that attempts to outperform the market. And even within a given cycle, a successful strategy may become neutralized or unsuccessful as other investors adopt the same strategy.

Because of these limitations, smart-beta funds are generally not wise for short-term investors, but they may be appropriate as a long-term, buy-and-hold strategy in a diversified portfolio. Diversification is a method used to help manage investment risk; it does not guarantee a profit or protect against investment loss.

Smart-beta investments may not use this term, and you might already own one or more such funds without thinking of them in that category. With any smart-beta fund, be sure you understand the factors used to select and weight underlying investments.

The S&P 500 is an unmanaged group of securities that is considered to be representative of the U.S. stock market in general. The performance of an unmanaged index is not indicative of the performance of any specific investment. Individuals cannot invest directly in an index. Past performance is not a guarantee of future results; actual results will vary.

The principal value of mutual funds and exchange-traded funds will fluctuate with changes in market conditions. Shares, when sold, may be worth more or less than their original cost. Supply and demand for ETF shares may cause them to trade at a premium or a discount relative to the value of the underlying shares.

Mutual funds and exchange-traded funds are sold by prospectus. Please consider the investment objectives, risks, charges, and expenses carefully before investing. The prospectus, which contains this and other information about the investment company, can be obtained from your financial professional. Be sure to read the prospectus carefully before deciding whether to invest.

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