What is Smart Beta?

When investors talk about indexing, that has traditionally meant something that looks like the S&P 500 index. In recent years, indexing has grown far beyond its traditional roots and it now seems more common for index funds and ETFs to track indexes that look nothing like the S&P 500. Most of these new funds are commonly referred to as “smart beta” funds. It’s an ill defined term, but let’s explore what it means.

The Traditional Rules

Ignoring the technical details, the two primary characteristics of traditional indexes are:

1. Broad coverage of the intended asset class.
2. Weighting by size (market cap).

Some of the most popular indexes are constructed this way: the S&P 500, MSCI EAFE, Wilshire 5000, etc. The S&P 500 aims to represent large US companies, so it contains 500 large US companies (Rule #1) and it weights them by market cap (Rule #2).

Breaking the Rules

If all indexes were set up this way, academics and fund companies wouldn’t have anything interesting to do. So the obvious solution is to break the rules.

The first approach was to break Rule #1 by targeting stocks with certain attributes. Value vs growth stocks was a common way to split the stock market. Vanguard’s value index fund only contains US stocks that have “value” characteristics. It excludes the remaining stocks that it considers to be “growth.” But this fund still weights the filtered list of stocks by market cap, obeying Rule #2.

Eventually indexes that broke Rule #2 were introduced. In 2005, Research Affiliates came out with Fundamental Indexes that weighted stocks not by market cap, but other measures of size: sales, earnings, etc. But these indexes still obeyed Rule #1 by not excluding stocks with certain characteristics.

Of course, there are now funds that break both rules. Take a look at Guggenheim’s S&P 500 Pure Value ETF (RPV). First, it filters US stocks to those showing strong value characteristics — a filter that’s far more strict than Vanguard’s value fund above. Then it weights the stocks, not by market cap or another measure of size, but by their value scores. It’s a far more intense “value” fund than Vanguard’s.

Why Bother?

So why are investors attracted to these “smart beta” indexes and funds? Most of these funds are capturing effects that students of investing already know about — the strong track records associated with attributes like value, small cap, momentum, profitability/quality, and low beta/volatility. The various “smart beta” funds attempt to capture these effects in slightly different ways, in different combinations, or in different asset classes, but really that’s all they’re doing.

And if you accept that these effects work, “smart beta” funds that provide a more precise and effective exposure to them can be a useful part of your portfolio.

Appendix

Interested in some examples? Here are some smart beta alternatives to traditional US stock index funds.