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What is smart beta?

There is a lot of confusion in the investment industry around the definition of ‘smart beta’. Even the term itself, which is viewed as an industry buzzword, is not universally accepted. The same concept is also referred to as scientific beta, advanced beta, alternative beta, alternative indexing and factor investing, among others.

Irrespective of nomenclature, all these terms refer to indices that are constructed and rebalanced to an alternative set of weights for the purpose of outperforming equivalent market-capitalisation-weighted indices with similar or reduced risk characteristics. In fact, all smart-beta indices share three features that collectively contribute to the risk-adjusted outperformance of the equivalent market-capitalisation weighted approach. Firstly, they are not reliant on market-capitalisation weights; secondly, they systematically rebalance back to a set of target weights to maintain intended exposures; and, thirdly, they are sufficiently diversified to effectively exploit the negative cross-sectional correlations and noise inherent in financial markets.

Smart beta indices typically fall into three categories, with a focus on return, risk or both return and risk:

1) Return focused

Equal weighting: where all companies in an index are weighted equally, irrespective of how large or small. Such indices have a small company bias relative to the equivalent market capitalisation weighted index.

Fundamental weighting: where companies in an index are weighted according to their economic size, using, for example, an average of stock weights proportional to sales, dividends, cashflow, and book value (the reason for averaging is that, taken individually, these simple measures all have flaws). Fundamental indices break the link between stock prices and weights and have a pronounced, albeit dynamic, value bias relative to the equivalent market capitalisation weighted index.

2) Risk focused

Risk weighting: where companies in an index are weighted according to their volatility with the aim of improving portfolio efficiency by making assumptions about future volatilities and/or correlations, generally based on historical observations. Risk-weighted indices include simple, non-optimised approaches such as volatility weighting and equal risk contribution, as well as more sophisticated volatility minimisation  approaches using an optimisation (e.g. risk efficient, maximum diversification, minimum variance and targeted volatility).

3) Return and risk focused

Factor (or risk) premia weighting: where companies in an index are weighted according to a factor premium (single-factor) exposure or factor premia (multifactor) exposures. These single or multiple factors are sources of excess returns that arise and persist in equity markets because of behavioural and structural anomalies. Within equities, single factors include value, quality, momentum, small size and low volatility. Multifactor indices employ a selected combination of various single factors, either within an asset class or across multiple asset classes. Factor premia indices can be implemented via long-only strategies (factor premia) and long/short strategies (alternative factor premia).

The smart beta index employed for portfolio-tracking purposes may be one of three index forms: a third-party index licensed from an index provider in exchange for a fee (with the intellectual property being owned by the index provider); a custom index designed by an investment management firm (with the intellectual property being owned by the investment management firm) but the index calculation and administration being outsourced to a reputable index-calculation agent/administrator; or a self index, effectively an algorithm, implemented on the desk by a fund manager.

Overall, smart beta can be viewed as a third approach to investing (passive management through market-capitalisation-weighted indexing and active management being the other two) that combines the benefits of both active and passive management. Specifically, smart beta aims to achieve above market returns or below market risk, or both, by gaining targeted exposure to factor premia that are implemented via tracking non-market capitalisation weighted indices, thereby retaining the numerous benefits of conventional indexing such as simplicity, objectivity, transparency and relatively low costs.