17. Smart Beta

Smart Beta

Smart beta has a broad meaning, but we can say in practice that when we use the universe of stocks from an index, and then apply some weighting scheme other than market cap weighting, it can be considered a type of smart beta fund. By contrast, a purely alpha fund may create a portfolio of specific stocks, not related to an index, or may choose from the global universe of stocks. The other characteristic that makes a smart beta portfolio "beta" is that it gives its investors a diversified broad exposure to a particular market.

Smart Beta is a word that originated in the finance industry in the 2000s, and its use has evolved over time. Smart Beta originally referred to a specific kind of alternative weighting, which is fundamental weighting. Alternative weighting refers to anything other than market cap weighting. Market cap weighting is very common because it reflects the market movement (big companies affect the market more than small ones do).

Fundamental weighting uses accounting measures such as book value to weight the stocks. So, for instance, a smart beta fund would implement fundamental weighting by buying more shares of stocks whose market price decreased but book value did not change; they would also sell shares in stocks whose market price increased but book value did not change. Other fundamentals could be dividends issued or price earnings ratios. This fundamental weighting applying a bit of “alpha” to a beta fund by using weighting rules that are designed to overweight stocks that may generate better outcomes.

Other kinds of alternative weighting that have also taken on the label “smart beta” include square root of market cap or equal weighting. The square root of market cap helps to reduce the impact of large stocks, and so it favors small cap stocks. Equal weighting invests an equal dollar amount in each stock.

Factor investing, which we’ll cover in depth in module 4, has also been referred to as a type of smart beta because it looks for measurable factors (fundamental data, but also any data source) that can indicate whether to give more or less weight to a particular stock (and hence, be a bit “smart” about its weights).