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Summary Smart beta strategies are not always smart and are not just beta. USMV is a smart beta strategy that demonstrates alpha. Don’t buy USMV to reduce volatility, buy it because you believe it has alpha. Smart beta is active management and you should understand the source of outperformance for a given strategy. Smart beta strategies are not always smart and are not just beta. Smart beta ETFs can be used to take active positions relative to a given index. The goal of the smart beta ETF is to outperform the index, after adjusting for risk. This is the same goal as any other active investment strategy. There needs to be an underlying reason the active positions, in a smart beta ETF, will continue to outperform on a risk adjusted basis. The Theory: A great example is the iShares MSCI USA Minimum Volatility ETF (NYSEARCA: USMV ). USMV purchases a portfolio of U.S. equities such that volatility is minimized, given a set of constraints. From a marketing perspective it is a great idea. Who doesn’t want to buy lower volatility stocks? However, if USMV does not offer alpha then it serves no purpose in a portfolio. Now, let’s bring in the theory. CAPM says that all returns are explained by their exposure to market beta. CAPM assumes markets are efficient & normally distributed. I am not saying that CAPM is a perfect theory, but it should be the starting point for an analysis. The Fama-French Three Factor Model was the first “smart beta” model. The three factor model says there are other factors that can explain the return and tilting to those may factors increases risk adjusted return, i.e. alpha. Market inefficiencies need to exist for CAPM not to work and for a given smart beta strategy to work. Inefficiencies can come from several places including market structure, behavioral, information availability and other factors. The Formula: Smart Beta Strategy Return = Beta*(Market Return) + Alpha. The alpha can come from factor tilts that occur in smart beta. This assumes the risk free rate is 0.0%. The Inefficiency: Please don’t say you want to buy USMV to lower your volatility! You can buy the Vanguard S&P 500 ETF ( VOO) + cash to achieve the same exact beta, it is also a lot cheaper. Buy USMV for the correct reason. USMV outperforms the market, after adjusting for risk, because it picks up a market inefficiency. USMV has been shown to have an alpha of 4.2% from October 2011 to July 2015. (click to enlarge) It is important to understand the market inefficiency that USMV relies on. The inefficiency is from U.S. mutual funds owning cash and wanting a beta of 1 or higher. For a mutual fund to have a beta of 1, while also owning cash, it must purchase higher beta stocks. Therefore higher beta stocks (high volatility stocks) receive a higher flow of dollars. This makes lower beta stocks (lower volatility stocks) are cheaper than they otherwise would be. USMV owners are effectively taking their excess return from U.S. equity mutual fund investors. Conclusion: When Investing in Smart Beta… Certain smart beta strategies outperform the index due to inherent market inefficiencies. Understand the underlying reason why a smart beta strategy will outperform an index (at least check that it shows alpha historically after adjusting for market beta). Don’t buy USMV to reduce volatility, buy it because you believe it has alpha. If you want to reduce volatility then sell risky assets and buy cash. Smart beta is active management and you should understand the source of outperformance for a given strategy. USMV has historically shown positive alpha of 4.2% and I expect the market inefficiency that it relies on to continue. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. Share this article with a colleague