What is smart beta?
Smart beta is a rules-based portfolio construction process. Traditional index-linked strategies rely on price to decide which stocks to invest in and how much of each to hold. This results in the traditional market cap index, which is based on the Capital Asset Pricing Model (CAPM). But 2 of the main assumptions of CAPM are that the market is efficient and investors are rationale. In reality, this is not the case and stock prices do not always accurately reflect a company’s economic footprint. Smart beta strategies seek to exploit these market inefficiencies by anchoring on factors other than price. In other words, smart beta strategies break the link between price and portfolio weight in an effort to deliver better-than-market returns.
What are examples of smart beta strategies?
By its broadest definition, any portfolio construction process that doesn’t rely on price to select and weight stocks is a smart beta strategy. To keep the “smart” in smart beta, the approach should be systematic and rules based, proven to offer the potential of outperforming the market—in other words, both the approach AND the implementation matter.
The most commonly cited forms of smart beta are fundamental weighting, volatility weighting, dividend weighting, and equal weighting. Research Affiliates is widely credited with introducing the first fundamentally weighted index in 2005.
What is the difference between market-cap weighting and fundamental weighting?
Market-capitalization, or market-cap, weighting relies on price to select and weight stocks in a portfolio. A company’s market cap is the prevailing price of its stock multiplied by the number of its shares outstanding. This traditional approach offers investors some attractive benefits, but it also has some potential flaws. As a company’s stock price goes up or the company issues more shares, the portfolio will hold a larger exposure to the company. If a stock’s price rises relatively more than the fundamental value of the company, the result can be a portfolio that holds relatively more overvalued stocks than undervalued stocks. Investor behavior often creates an increase in price volatility thus driving the gap between price and fundamentals further apart and increasing concentration risk at the sector, country, and/or stock level.
In contrast, a fundamental weighting approach uses measures of company size—namely, sales, cash flow, dividends, and book value—to sever the link between price (market capitalization) and portfolio weight. It then methodically contra-trades when prices deviate from fundamentals, selling when stock prices have rallied and buying when they are out of favor. A rebalancing premium is generated from systematically buying low and selling high.
Why consider smart beta?
Smart beta strategies offer the potential for better-than-market returns along with the benefits of traditional index-linked strategies including broad market exposure, rules-based implementation, transparency, high capacity, and low cost. Smart beta strategies can complement or replace both active strategies and passive (market-cap) indices and are a strong addition to the long-only equity portion of a portfolio.
What role did Research Affiliates play in the smart beta evolution?
Although the term “smart beta” is somewhat new, the concept is not. In 2005, Rob Arnott and Jason Hsu, along with their co-author Philip Moore, published the article "Fundamental Indexation" in the Financial Analysts Journal. They introduced a new way of thinking about index investing, a rules-based approach to security selection and weighting that was unrelated to the popular market-cap approach that began in the mid-1970s. Also, in 2005, Research Affiliates introduced the Research Affiliates Fundamental Index™, or RAFI™, and a series of investment vehicles tied to the index (exchange-traded funds) were launched. Clearly, Research Affiliates was offering investors smart beta strategies long before the term smart beta even existed.