What Is Smart Beta?
Let me explain smart beta to you directly: it's an investing method that merges the advantages of passive investing with those of active strategies. It stems from the capital asset pricing model (CAPM), which I know was created to outline the link between risk and return. In CAPM, beta measures a security's volatility or systemic risk against the overall market.
Over the years, economists have built on CAPM to examine other factor premiums—things like momentum and growth—that help explain and predict risk and expected returns more effectively. That's the foundation you need to grasp here.
Key Takeaways
Here's what you should remember: smart beta aims to blend passive investing benefits with active strategy advantages. It relies on alternative rules for index construction, moving away from traditional market-cap-based indices. The focus is on capturing investment factors or market inefficiencies through a rules-based, transparent process.
These strategies often use weighting schemes based on volatility, liquidity, quality, value, size, and momentum. And as of February 2024, smart beta ETFs were handling about $1.56 trillion in combined assets—that's the scale we're talking about.
What Are Smart Beta Strategies?
Smart beta strategies, as I see them, target alpha by using these factors to build alternative indices, distinct from market-cap-based ones. This method seeks the optimal diversified portfolio. Essentially, it's a mix of the efficient market hypothesis and value investing principles.
One issue investors like you might have with market-cap-weighted indices is that they favor yesterday's winners—companies that have already ballooned in size. Smart beta applies to various asset classes, including equities, fixed income, commodities, and multi-asset setups.
Note on Smart Beta
Keep in mind that smart beta strategies are most commonly used in exchange-traded funds (ETFs)—that's where you'll encounter them frequently.
How Smart Beta Works
Smart beta involves investment strategies that prioritize index rules different from market-cap weighting. These emphasize capturing factors or inefficiencies transparently and rules-based. The rise in popularity comes from investors wanting better portfolio risk management, diversification by factors, and improved risk-adjusted returns over cap-weighted indices.
These strategies passively track indices but incorporate alternative weightings like volatility, liquidity, quality, value, size, and momentum. They don't follow standard indices like the S&P 500 or Nasdaq 100; instead, they target exploitable market areas.
Common Areas of Focus for Smart Beta ETFs
- Volatility, where funds track indices of low-volatility securities.
- Momentum, weighting stocks based on their price momentum over a set period.
- Equal-weighting, rebalancing an index to give equal weight to each component, avoiding bias toward larger market caps.
Selecting Smart Beta Strategies
Smart beta is a wide category of products built on custom indices designed to outperform a sector or the market. You have many options, and no one fits every investor. Some managers identify value-creating, intuitive smart beta ideas prescriptively.
Equity smart beta tackles inefficiencies from market-cap benchmarks. Funds might take a thematic approach, addressing mispricing from short-term gain seekers. Managers could weight by fundamentals like earnings or book value, not market cap.
Or they might use a risk-weighted method, building indices on future volatility assumptions. This could involve historical performance analysis and correlations between risk and return. As a manager, you'd decide how many assumptions to include, possibly combining different correlations.
Smart Beta Popularity
Even though smart beta funds charge higher fees than basic ones, they stay popular. As of October 2024, there were about 1,041 smart beta ETFs in the U.S., with total assets at $1.56 trillion—up from $616 billion in 2016. That's the growth trajectory you should note.
Examples of Smart Beta Funds
Let me give you three examples of ETFs using different smart beta strategies for value, growth, and dividend appreciation.
The Vanguard Value Index Fund ETF Shares (VTV) tracks the CRSP US Large Cap Value Index, using ratios like price-to-book, forward P/E, historical P/E, dividend-to-price, and price-to-sales to determine value. It had $132.1 billion in AUM as of January 2025.
The iShares Russell 1000 Growth ETF (IWF), with $105 billion in net assets as of January 2025, mirrors the Russell 1000 Growth Index, selecting based on price-to-book, medium-term growth forecasts, and sales-per-share growth.
The Vanguard Dividend Appreciation Index Fund ETF Shares (VIG) follows the Nasdaq US Dividend Achievers Select Index, picking firms that raised dividends for 10 years and weighting by market cap. Its AUM was $87.8 billion as of January 2025.
Tip for Advanced Strategies
If you're looking to advance your investing and trading, consider checking guides on elevating your strategy to maximize returns—that's a step you might take.
The Bottom Line
In summary, smart beta uses factors like value or quality—believed to drive outperformance—to build indices differing from market-cap-weighted ones. These are alternatives to traditional indices, but the ETFs tracking them remain passively managed. That's why smart beta sits between active and passive strategies in the investing spectrum.
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