An index fund often uses the market capitalization of component companies in the index as the basis for constructing the fund. In contrast, smart beta funds use rules-based indexes designed to provide exposure to certain markets and focus on certain factors, or to enact specific investment strategies. Smart beta funds provide alternatives to passive index investing and seek to provide superior risk-adjusted performance. Some have likened smart beta funds to hybrid investment vehicles with aspects of passive indexes, as well as aspects of actively managed mutual funds.

Market Capitalization

Some of the most prevalent stock indexes are market-weighted, including the S&P 500. In this type of index, individual components are weighted according to the company's market capitalization. A company’s market capitalization is determined by taking the price of the stock multiplied by the number of outstanding shares. Thus, companies with a larger market capitalization have a larger impact on the index's value. These indexes often provide a benchmark for the overall economy. Exchange-traded funds that track the indexes provide investors an easy way to invest with low expenses.

Smart Beta Funds

There are definite drawbacks to passive investing with indexes. Smart beta funds use transparent rules-based strategies to provide greater upside for investors while keeping expenses low. More active investment strategies have historically been out of reach for smaller investors due to high costs. Smart beta funds seek to create alternative investment vehicles that provide exposure different from that of index funds. Many different types of strategies are grouped under the moniker of smart beta. 


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