Definition of smart beta

Some investors are moving away from traditional market capitalisation-based indices to alternative strategies, known as smart beta, in search of better returns and lower costs amid volatile markets and an uncertain economic climate. [1]

Smart beta is a rather elusive term in modern finance. It lacks a strict definition and is also sometimes known as advanced beta, alternative beta or strategy indices.

It can be understood as an umbrella term for rules based investment strategies that do not use the conventional market capitalisation weights that have been criticised for delivering sub-optimal returns by overweighting overvalued stocks and, conversely, underweighting undervalued ones.

Smart beta strategies attempt to deliver a better risk and return trade-off than conventional market cap weighted indices by using alternative weighting schemes based on measures such as volatility or dividends. [2]

Smart beta refers to an investment style where the manager passively follows an index designed to take advantage of perceived systematic biases or inefficiencies in the market. It therefore costs less than active management, since there is less day-to-day decision-making for the manager, but since it will, at the very least, have higher trading costs than traditional passive management (which minimises those costs), it is a pricier option. [3]

Among the best known alternatives to market cap weighting are the fundamentally weighted indices developed by Research Affiliates in 2005 which rank their constituents by book value, dividends, sales, and cash flow.

However, even a naive weighting scheme such as equally weighted indices can be described as smart beta.

Interest in smart beta indices has been fuelled by the global financial crisis of 2007-08 which prompted many investors to become more focused on controlling risks than simply maximising their returns. 

One of the key attractions of smart beta is that it is less expensive for investors to evaluate the worth of these strategies than to analyse and monitor the performance of active managers.

Smart beta can also be understood as the returns that can be generated from illiquid or private markets such as real estate and infrastructure which offer attractive risk return trade-offs and which can provide important diversification benefits when added to a conventional portfolio of equities and bonds.

Some investors would also include thematic strategies under the smart beta umbrella by building portfolios that provide exposure to demographic trends or to particular sectors such as agriculture, timber and natural resources. [4]

Smart beta options might include fundamental indexed investments or catastrophe bonds.