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What is 'Smart Beta'

Smart beta defines a set of investment strategies that emphasize the use of alternative index construction rules to traditional market capitalization based indices. Smart beta emphasizes capturing investment factors or market inefficiencies in a rules-based and transparent way. The increased popularity of smart beta is linked to a desire for portfolio risk management and diversification along factor dimensions as well as seeking to enhance risk-adjusted returns above cap-weighted indices.

BREAKING DOWN 'Smart Beta'

Investment managers that follow a smart beta investment strategy seek to passively follow indices, while also taking into account alternative weighting schemes such as volatility. That's because smart beta strategies are implemented like a typical index strategies in that the index rules are set and transparent. Smart Beta strategies will differ from standard indices, such as the S&P 500 or the Barclays Aggregate, in that the indices focus on areas of the market that offer an opportunity for exploitation.

Since the manager is implementing the strategy in a passive index way, this type of investment approach is estimated to cost less than active investment management, and likely to cost marginally more than traditional market-cap weighted index management. The goal of smart beta is to obtain alpha, lower risk or increase diversification in a more cost-effective manner.

There is no single approach to developing a smart beta investment strategy, as the goals for investors can be different based on their needs, though some managers are prescriptive in identifying smart beta ideas that are value creating and economically intuitive. Equity smart beta seeks to address inefficiencies created by market-capitalization-weighted benchmarks. Managers may take a thematic approach to managing this risk by focusing on mispricing created by investors seeking short-term gains.

Managers may also choose to create or follow an index that weights investments according to fundamentals, such as earnings or book value, rather than market capitalization.

A risk-weighted approach to smart beta involves the establishment of an index based upon assumptions of future volatilities. This may involve an analysis of historical performance and the correlation between an investment's risk relative to its return. The manager must evaluate how many assumptions he or she is willing to build into the index, and can approach the index by assuming a combination of different correlations.

The smart beta investment approach applies to asset classes outside of equities to include fixed income, commodities and multi-asset classes.

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