Smart Beta

What Is Smart Beta?

Smart beta is a family of investment strategies that sits between traditional index investing and active management. Like a conventional index fund, a smart beta product follows a set of published rules rather than relying on a manager's individual stock picks. The difference is in what those rules measure. A standard index weights each company by its market capitalization, so the largest companies take up the biggest share of the portfolio. A smart beta strategy instead builds its portfolio around one or more factors, which are characteristics that research has linked to returns over long periods.

Common Factors and Weighting Methods

Smart beta strategies often target factors such as:

• Value, which favors companies that look inexpensive relative to measures like book value or earnings
• Size, which favors smaller companies
• Momentum, which favors stocks that have recently performed well
• Low volatility, which favors stocks with smaller price swings
• Quality, which favors companies with strong profitability and stable balance sheets
• Equal weighting, which gives every holding the same weight regardless of size

Some strategies combine several factors, and each one is rebalanced on a set schedule.

Advantages and Disadvantages

Supporters point out that smart beta offers a rules-based, transparent way to pursue factor exposures that were once mainly available to active managers. Because the rules are fixed, the strategy depends less on any one person's judgment.

Critics note several drawbacks. Factors can underperform for long stretches, sometimes years, and a factor that worked in the past may not continue to do so. Popular factor strategies can also become crowded, which may reduce their advantage. Smart beta products usually charge higher expense ratios than plain market index funds, and frequent rebalancing can add trading costs and tax consequences.

Why It Matters to Investors

Smart beta helps explain what a fund is actually tracking. Two funds may both be labeled as broad stock funds yet hold very different mixes of companies, and the reason often lies in their factor tilts. Reading a fund's index methodology and rebalancing schedule shows how its holdings are chosen and how often they change.