Smart beta strategies use transparent rules to build portfolios with specific characteristics that are important for explaining security returns. Such characteristics—e.g. value or momentum or quality—are also known as factors. Smart beta takes well-known factors long used in active strategies and expresses them in passive form. In practice, this means choosing strategies that use pre-specified rules to keep fairly constant exposures to factors with desirable long-term return characteristics that include positive expected return, and, possibly, low volatility or low correlation with other sources of return. Examples of equity smart beta strategies include individual funds that systematically overweight each of the following:

  • Value stocks or small stocks.
  • High dividend-paying stocks.
  • Momentum stocks or quality stocks
  • Low beta, low volatility stocks

Of course, smart beta strategies can encompass asset classes beyond equities. Value and momentum strategies have also performed well in bonds, currencies, and commodities. Also, some smart beta strategies take a multi-asset approach that seeks to better allocate among factors such as economic risk, inflation risk, real rate risk, credit risk, liquidity risk, or political risk. Finally, there are some strategies, for example in fixed income, that seek to outperform existing indices by avoiding quirks of how those indices are constructed—e.g., by softening the hard cutoffs based on maturity or rating.

Who should buy these strategies?

Passive Index Funds are for investors who believe particular markets are efficient or who believe markets are inefficient but do not believe they can successfully identify skillful active managers or attractive factor exposures. Index funds offer the additional benefits of higher transparency, lower transactions costs, and lower management fees.

Active Strategies are for investors who believe markets are inefficient, and they believe they can successfully identify skillful active managers.

Smart Beta is for investors who believe that markets are inefficient in very specific ways, and that they can identify factors with positive risk-adjusted returns. Smart beta strategies can also appeal to investors who would normally invest in active strategies, but whose fund size is very large compared to the capacity of most active strategies.