Smart Beta


Smart beta strategies are designed to add value by systematically selecting, weighting, and rebalancing portfolio holdings on the basis of factors or characteristics other than market capitalization.




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 rational. 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.


Smart Beta Basics


Before the Fundamental Index, investors had two choices of strategy—


Active or Passive


Each had its own argument to make.

Investors who believed markets were largely efficient, or doubted their ability to select skillful managers, leaned toward low-cost market capitalization–weighted index funds.

Investors who believed markets were inefficient and had confidence in their manager selection process were more inclined toward active management.


But both were “false choices.”

Market cap–weighted equity index funds automatically increase their exposure to stocks whose prices appreciate and reduce their exposure to stocks whose prices depreciate. As a result, they tend to overweight overvalued stocks and underweight undervalued stocks, which can lead to an increase in concentration risk in exactly the wrong stocks!

Active management, unlike a rules-based objective strategy, is not transparent, comes with high fees, and often underperforms its benchmark over long time periods, especially when evaluated on a net-of-fee basis. Active managers with skill do exist, but are difficult to find. Typically, a great deal of time and resources are required first to identify them and then to monitor them over time. Moreover, when an active manager does outperform, the excess returns are often due to the manager’s style being in favor rather than to true skill. Indeed, the returns are reflective of those a “smart beta” strategy could provide at a much lower fee.

In practice, each of the choices investors can make-active or passive-has the potential to result in unwanted risks and disappointing returns.


What “Smart Beta” Means to Us

The controversial term “smart beta” is used so broadly in the marketplace that it risks becoming meaningless. This article describes the characteristics of equity strategies that, in our view, merit the smart beta designation.


What Makes Alternative Beta Smart?

A smart beta strategy should be “low cost, transparent and systematic,” according to Towers Watson. Our research suggests many alternative beta strategies fall short..


The Promise of Smart Beta

Beyond the debate over definitions, smart beta strategies can be the prime alternative to active management for our times just as cap-weighted index funds served so admirably in that role for the past four decades.


Part 1 - The Genesis of Smart Beta Investing

What is smart beta and how can it help investors? In the first part of a new series, Jason Hsu relates smart beta to traditional passive and active management. 


"In periodically rebalancing to target weights that are unrelated to price, smart beta strategies engage in value investing: They buy low and sell high.”


Rob Arnott, Chairman


Investing in Smart Beta


Smart beta strategies offer investors an uncompromised choice.


Smart Beta, the Research Affiliates Way…

Breaks the link between price and portfolio weight

The most important component of smart beta is breaking the link between the price of an asset and its weight in the portfolio.

Our research indicates that any structure which breaks the link between price and weight outperforms a cap-weighted index over the long run. Such strategies include fundamental weighting, equal weighting, minimum variance, and Shiller CAPE index. Breaking the link can be done simply and inexpensively and has been shown to have good historical efficacy in regions and markets all over the world.

Strategies that use market capitalization to select and/or weight securities, such as cap-weighted value indices, leave money on the table because of the return drag afflicting all cap-weighted strategies, and are not smart beta as defined by Research Affiliates.


Regularly rebalances

At Research Affiliates, we believe the largest and most persistent active investment opportunity is long-term mean reversion. Our fundamental index approach systematically and methodically sells recent winners and buys recent losers. This regular periodic rebalancing flows naturally from our central belief in mean reversion—undervalued securities will ultimately rise to their normal valuation level.


Retains the positives of passive indexing

The benefits of a passive strategy are all part of the fundamental index approach: transparency, low cost, high capacity, rules based, and systematic. Costs are kept low in both due diligence and monitoring, and portfolios are well diversified without stock, industry, or country concentrations.


A Research Affiliates Smart Beta Investor…


Favors simplicity

When investors understand the investment philosophy, construction process, and return drivers around a strategy, they are more likely to understand why it may underperform over part of a market cycle. The transparent, rules-based nature of smart beta is simple to understand. In contrast, an active strategy may be more complex and less transparent, so that investors are less likely to understand why it may underperform over part of a market cycle. This often leads to poor decision making by investors who buy active strategies after a period of outperformance and sell them when they start to underperform.


Practices patience

Mean reversion is unreliably reliable and, as such, demands a patient investor. Prices revert to “normal” valuations at varying paces and over fluctuating time frames. When markets do return stocks to more normal valuations, the valuation may be the stock’s historical mean or a completely different level. Investors who commit to a smart beta strategy should do so with a 10-year horizon, and memorialize their rationale for future decision makers.

Understands the impact of current valuations

Rising valuations, above their historical normal levels, can artificially inflate past performance and reduce the future return prospects of a smart beta strategy. Higher valuations create an added risk of mean reversion down to historical valuation norms, threatening an abrupt reversal of past performance. An investor must look “under the hood” to understand how a strategy produces its alpha. Value-added can be structural—a plausible source of future alpha. Or it can be situational—a consequence of rising enthusiasm for, and valuation of, the selected strategy. Netting out the effect of changing valuations on past returns results in a more reliable estimate of a strategy’s true alpha-producing ability. 


Can live with the ups and downs of contrarian investing

The fundamental index approach rebalances by selling winners and buying losers, a quintessentially contrarian exercise, also the wise council of the father of security analysis, Benjamin Graham. Investors considering this strategy need to be honest with themselves about their ability to persevere during periods of underperformance while they await the market’s recognition that their portfolio’s undervalued securities are indeed undervalued, and the market’s subsequent shift to value them consistent with their true underlying fundamentals. For most investors, a contrarian strategy is a diversifying strategy, selected as one strategy among several in their portfolio. 


But smart beta is not every investor’s cup of tea…

Obviously not every investor is a smart beta investor. For those who prefer to own the broad market, to pay next to nothing for market exposure, and do not want and/or do not have the resources to play a performance-seeking game, a cap-weighted index strategy is a sensible choice. The market is not always efficient, however, and a cap-weighted index can assume disproportionately heavy concentrations in companies likely to be overvalued and light allocations in companies undervalued relative to their fundamentals.  


A Preference for Discomfort

Is the stock market inefficient or do investors have varying preferences? How does behavior affect wealth accumulation? Unpopular choices can result in improved outcomes.


The Confounding Bias for Investment Complexity

Complexity can dampen investor understanding, leading to poor investment decision making and ultimately derailing long-term financial goals—yet the bias toward investment complexity persists, reinforced by explanations that are behavioral in nature.


Slugging It Out in the Equity Arena

Research shows that smart beta strategies earn long-term returns around 2% higher than market-cap weighted indices. However, the stock market is an equilibrium market, begging the question, who’s on the other side of the smart beta trade?


“A smart beta strategy should be simple in structure, transparent in its source of value added, balance risk against return, and keep implementation costs low.”


Chris Brightman, Chief Investment Officer


Evolving Smart Beta


Smart beta strategies can also be described as portfolios that tilt toward various,
or combinations of, equity factors.


Smart Beta Viewed as a Factor Framework


Today smart beta is often being viewed through the lens of risk and return drivers—or factors. These are investment characteristics that help explain the behavior of a security. Driven by risk preferences and or behavioral anomalies, factors have been shown to generate excess returns over long time horizons. Some factors are robust, whereas others appear to be the result of data mining.

Academic literature provides useful guidance on how to determine whether a factor truly contains a return premium.

The factor premium does not materially change because of minor variations in the factor definition or construction.

The factor is robust over time.

  • Even after numerous database revisions and extensive out-of-sample data testing, the factor retains its persistence.
  • The factor is vetted, replicated, and debated over decades in top academic journals.

The factor works across geographies.

The persistent factor premium can be credibly explained, supported by

  • financial theory or macro risk exposures.
  • a deep-rooted behavioral bias present in a meaningful fraction of investors.
  • an institutional or structural feature that cannot be easily changed.

The equity factors that appear to be most robust over time and across countries are

Market           Value          Momentum          Low Volatility

The metric and number of metrics used to define each of these factors can vary significantly across strategies.


Smart Beta Beyond Equities


The investment industry continues to evolve the concept of smart beta beyond the equity asset class. Commodities and fixed income are two of the more popular asset classes now attracting smart beta strategies.



Unlike in the equity space, weighting in traditional commodity indices are only loosely linked to price. These do however suffer from naive construction rules that lead to poorly diversified portfolios, negative roll returns and ultimately results in a return drag.

To improve on the performance of existing indices, smart beta commodity strategies tap into systematic sources of return, namely roll yield—both across different commodities and along the term structure of contracts—and momentum. These are the primary drivers of excess returns in commodity investing.

Fixed Income

Traditional corporate bond indices weight their constituents based on the amount of debt outstanding. This means that the most indebted issuers have the largest index weights, potentially overexposing investors to firms with poor credit quality and high corporate leverage (based on debt to assets) without necessarily improving returns.

Sovereign bond indices are weighted by the market value of outstanding debt, where countries with the most debt receive the largest weights. The quality of these debts and the countries’ ability to service and ultimately repay them, is often not proportional to the size of the debt burden.

Applying the principles of smart beta to fixed income means emphasizes debt-service capacity, severing the link between outstanding debt and portfolio weight. This approach avoids overexposure to companies or countries with high debt burdens and credit risk.