Smart beta
Also known as: factor investing
Smart beta describes an indexing approach that builds a by weighting holdings according to specific characteristics, called factors, such as value, quality, low , or , rather than weighting them simply by market capitalization the way a traditional does. It sits somewhere between fully passive index investing and fully active picking, following a fixed, rules based methodology like a does, while deliberately tilting away from the market as a whole the way an active manager might.
A traditional market capitalization weighted automatically gives the largest companies the largest weight in the , regardless of whether those companies are attractively priced or particularly high quality at the moment. A smart beta fund instead applies a defined rule, for example ranking companies by valuation and overweighting the cheapest ones, or ranking companies by profitability and overweighting the most profitable ones, and rebalances the periodically according to that same rule.
Because the underlying factors, such as value or quality, have historically shown periods of outperforming and periods of underperforming the broad market, smart beta strategies do not outperform in every environment, and a specific factor tilt can lag the broader market for extended stretches even if it has shown a long-term edge historically. Smart beta typically charge more than a plain market capitalization weighted , reflecting the more involved methodology, but usually much less than a traditional actively managed fund, since the process is still rules based and does not involve ongoing manager judgment.