What Is Smart Beta?
Smart beta represents an innovative investment strategy that merges the strengths of both passive and active investment approaches. It aims to harness the advantages of each style, creating a compelling solution for savvy investors.
The roots of smart beta can be traced back to the Capital Asset Pricing Model (CAPM), which attempts to clarify the correlation between risk and return. In this context, “beta” measures the volatility or systemic risk of a security relative to the overall market. Over time, researchers have expanded upon CAPM to investigate various factor premiums, such as momentum and growth, which offer deeper insights into the relationship between risk and expected returns.
Key Takeaways
- Smart beta seeks to harmonize the benefits of passive investing with the strategies of active investing.
- This approach employs alternative indexing rules that differ from traditional market capitalization-based indices.
- It focuses on capturing investment factors or market inefficiencies in a transparent, rules-based manner.
- Smart beta can utilize varying weighting methods, including volatility, liquidity, quality, value, size, and momentum.
- As of February 2024, smart beta ETFs manage around $1.56 trillion in total assets.
What Are Smart Beta Strategies?
Critics of market-cap-weighted indices argue that they favor outdated stock winners—companies that have already seen substantial growth and command larger market capitalizations. Smart beta is versatile and can be applied across a range of asset classes, including equities, fixed income, commodities, and multi-asset portfolios.
Note
Smart beta strategies are commonly utilized within exchange-traded funds (ETFs).
How Smart Beta Works
Smart beta encapsulates a collection of investment strategies that prioritize index construction methods differing from standard market capitalization weighting. These strategies aim to capture investment factors or market inefficiencies in a consistent and transparent fashion. The rising popularity of smart beta correlates with a growing desire for portfolio diversification and effective risk management while also striving for enhanced risk-adjusted returns compared to traditional cap-weighted indices.
Smart beta funds typically pursue passive indexing methods while adopting alternative weighting approaches such as volatility, liquidity, quality, value, size, and momentum. Unlike conventional indices like the S&P 500 or Nasdaq 100, smart beta focuses on market segments ripe for exploitation.
Some key areas of focus within smart beta ETFs include:
- Volatility: Funds that track indices of low-volatility securities.
- Momentum: Stocks are weighted based on price momentum over specified periods.
- Equal-weighting: A method where each security holds the same weight, regardless of market capitalization.
Selecting Smart Beta Strategies
Smart beta serves as an umbrella term encompassing various investment products centered on custom-built indices aimed at outperforming either a sector or the broader market. With multiple investment options available, no single smart beta strategy fits every investor’s needs.
Some fund managers advocate for certain smart beta ideas deemed value-creating and economically sound. For instance, equity smart beta addresses inefficiencies arising from market capitalization-weighted benchmarks. Fund managers may take a thematic approach to mitigate risk by targeting mispricings influenced by short-term investor behavior.
Another strategy sees managers forming or following indices that weigh investments based on fundamental metrics—such as earnings or book value—rather than market capitalization alone.
Additionally, a risk-weighted approach to smart beta might involve establishing indices based on expected future volatility. This could necessitate analyzing historical performance against the correlation of risk relative to returns, prompting managers to determine how many assumptions to incorporate into the index design.
Smart Beta Popularity
Despite generally incurring higher fees than traditional funds, smart beta investments remain a favorite among investors. By October 2024, approximately 1,041 smart beta ETFs were trading in the U.S., with total assets amounting to over $1.56 trillion, significantly up from $616 billion in 2016.
Examples of Smart Beta Funds
The following ETFs exemplify diverse smart beta strategies targeting value, growth, and dividend appreciation:
The Vanguard Value Index Fund ETF Shares (VTV) tracks the CRSP US Large Cap Value Index, which assesses value using various fundamental ratios, including price-to-book (P/B) and price-to-earnings (P/E). As of January 2025, the fund boasts $132.1 billion in assets under management.
The iShares Russell 1000 Growth ETF (IWF), with net assets of $105 billion as of January 2025, strives to mirror the Russell 1000 Growth Index. This index selects components based on crucial factors such as price-to-book, projected growth rates, and sales-per-share dynamics.
The Vanguard Dividend Appreciation Index Fund ETF Shares (VIG) aims for similar returns as the Nasdaq US Dividend Achievers Select Index, focusing on firms that have consistently increased dividend payments over the past decade. As of January 2025, VIG has $87.8 billion in assets under management.
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The Bottom Line
Smart beta harnesses factors—attributes like value and quality believed to drive securities to outperform the market—to create indices that diverge from traditional cap-weighted approaches. While these indices provide alternatives to standard sector or market-wide securities, smart beta ETFs still operate under a passive management strategy. This unique positioning establishes smart beta as a distinctive approach that balances elements of both active and passive investment strategies.
