What makes smart beta smart?

The world’s first index mutual fund, the Vanguard 500 Index Fund, was launched in 1976. It served as a novel answer to a question posed by market observers of the day: If many mutual funds don’t outperform the indexes that serve as performance benchmarks, why not stop trying to beat the index and try instead to match it as closely as possible? 

The underlying theory was that by holding simple market exposure, also known as beta, an investor might get better results than by trying to beat an index through stock picking. Although passive investing took a while to catch on, index funds, and eventually exchange-traded funds (ETFs), became a staple in investor portfolios. The growth of index investing was aided along the way by academic research arguing that markets were efficient, that stock prices always reflect all available information, and that there's no point in trying to beat them. 

The limitation to this approach was that most traditional indexes—indeed, the very foundation of index investing—were constructed according to a single variable: market capitalization, or, in essence, price. The price of a single share times the number of shares outstanding equals the company’s market value or capitalization—its “size,” which determined its position and weight in the index. The biggest company got the biggest weight, regardless of whether that stock was a good investment on a go-forward basis.

This remains true today: The largest company in the S&P 500 Index is Apple, with an index weighting of about 3.9% index weight as of February 28, 2018. By comparison, if all 500 stocks in the index were to receive equal billing, Apple’s weight would be just 0.2%. Apple’s position in today’s capitalization-weighted index is a reflection of the company’s past growth, but what about its future growth? Investors in S&P 500 Index-based strategies who believe Apple’s best days are behind it have no choice but to own it as their largest holding. Conversely, capitalization-weighted indexes assign the smallest—often younger, faster-growing—companies proportionately smaller weightings.

The limitations of market capitalization as the sole organizing principle became clearer as a result of a growing body of academic research focused on the drivers of market returns. A landmark 1992 study by University of Chicago Professor Eugene Fama and Dartmouth College Professor Kenneth French argued that, based on history, focusing on smaller stocks and those with lower relative prices may improve a portfolio’s expected return.¹ This became known as the Fama/French three-factor model (the first factor being the market itself). In 2005, Robert Arnott, Jason Hsu, and Philip Moore of Research Affiliates, LLC, examined how a host of factors—sales, earnings, book value, cash flow, and dividends—affect market returns.²  Many other studies followed, generating interest in a proliferation of the potential factors that could serve as the organizing principle for an index.

The result of this work over the past two decades is the emergence of “smart beta” investing—named so because it seeks to identify and harness certain investment characteristics that research has shown to drive performance over time. As the number of smart beta ETFs has grown, so too has investor interest in the category, which represented nearly $350 billion in assets at the end of 2017, a growth rate of nearly 30% annually since 2012.³

One frequent question regarding smart beta is whether it's active or passive. In fact, it’s a little bit of both—active insight in a passively implemented vehicle. Smart beta strategies seek to combine the low-cost appeal of index investing with a selection, weighting, and rebalancing strategy that differs from traditional capitalization-weighted indexes. Consider the earlier example of equal weighting the S&P 500 Index to give more weight to the smaller, undervalued names at the expense of the larger names that have already experienced significant appreciation. In doing so, the equal-weighted version seeks to eliminate the past performance bias inherent in capitalization-weighted indexes. While the variety and popularity of smart beta funds have grown in recent years, all are defined by transparent methodologies that eliminate the need for ongoing research and portfolio management.