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What is 'Smart Beta'

Smart beta investing combines the benefits of passive investing and the advantages of active investing strategies.

The goal of smart beta is to obtain alpha, lower risk or increase diversification at a cost lower than traditional active management and marginally higher than straight index investing. It seeks the best construction of an optimally diversified portfolio. In effect, smart beta is a combination of efficient-market hypothesis and value investing. 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'

Smart beta strategies seek to passively follow indices, while also taking into account alternative weighting schemes such as volatility, liquidity, quality, value, size and momentum. That's because smart beta strategies are implemented like a typical index strategies in that the index rules are set and transparent. They 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.

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, for example.

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 volatility. 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.

Smart Beta was first theorized by economist Harry Markowitz via his work on modern portfolio theory.

Smart Beta Popularity

Smart beta strategies have seen huge inflows in recent years. According to ETF provider Invesco Powershares, from 2010 to 2015, Smart Beta ETFs took in more than 21% of U.S. equity ETF inflows, representing 12% of total ETF industry assets. According to Morningstar, smart beta assets under management in 2008 amounted to approximately $108 billion. As of 2015 that figure had grown to approximately $616 billion.

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