One of the biggest advantages of factor-based smart beta indices lies in the fact that they are regularly rebalanced. If done correctly, rebalancing can lead to optimal returns without racking up significant profit-draining fees.
Rebalancing involves buying and selling securities at intervals determined by each individual strategy. Intervals often range from monthly to quarterly, semi-annually and annually.
This mechanism is required so that strategies retain their stated purpose: for example, having exposure to the momentum factor or to small stocks. Changing markets, stock fundamentals and prices means factor exposure becomes weakened over time.
Factor indices are weighted by exposure to a certain factor, differing from benchmark indices which weight constituents by their size.
Since smart beta indices naturally have to be rebalanced more frequently than market-cap weighted alternatives, they carry slightly higher fees than passive benchmark indices. This means it is important to select the most appropriate rebalancing strategy, so as to simultaneously keep the index within its defined boundaries while also avoiding excessive costs.
The ultimate goal is to generate the best returns net of rebalancing fees.
Some strategies can require more frequent rebalancing than others, including momentum funds. Other factors, including small size and low volatility, tend to be preserved for longer.
For that reason, an index provider might choose to rebalance a momentum smart beta fund twice as often as a low-volatility fund, for instance.
Another advantage of rebalancing is that it is done in a rules-based and mechanical manner, which avoids the emotional biases that may be associated with mutual fund rebalancing.
Without enforced rebalancing, traditional passive benchmark indices can also become heavily overweight certain stocks or sectors. An extreme example of this was the tech bubble of the late 1990s.