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Smart beta describes investment funds that use a combination of active and passive investing principles. Learn more with the MoneySense Glossary.
Smart beta or strategic beta refers to funds or benchmarks that marry traditional passive index investing with active, rules-based strategies.
A smart beta portfolio modifies a market index with the goal of improving performance—adding alpha, or return in excess of the market return. (Beta is a measure of systematic risk, the risk of investing in the overall market.) This may involve changing the weights of each security in the index or including only securities with specific characteristics, or both.
For instance, the first smart beta exchange-traded fund (ETF), the Invesco S&P 500 Equal Weight ETF (RSP), holds an equal weight in each stock in the S&P 500 index. The S&P 500 index itself is market cap-weighted, meaning companies with the largest market capitalization have the largest weights and thus the largest impact on performance. Equal weighting reduces risk by increasing the portfolio’s diversity and capping the weight of each individual holding.
Since RSP was launched in 2003, myriad other smart beta products have been created to capture exposure to specific segments of the market. Many focus on factors such as size, value and quality, which have been shown to outperform the market over long periods or during specific phases of the economic cycle. As a result, smart beta and strategic investing are often described as factor investing.
Example: “Bob bought a smart beta ETF that tracked the S&P SmallCap 600 Equal Weight Index. He wanted to increase his exposure to stocks of smaller companies and he preferred the greater diversity of an equal-weight index. The top 10 positions accounted for about 2% of the total fund, compared to almost 6% with the market-cap weighted index.”
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