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. But the stock market is not always efficient, so stock prices don’t 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.

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.

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, and low cost.

What role did Research Affiliates play in the smart beta evolution?
The term “smart beta” is somewhat new, but smart beta strategies are not at all new. 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 market-cap  approach around since the mid-1970s. Also in 2005, Research Affiliates introduced the Research Affiliates Fundamental Index™, or RAFI™, around which 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.

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