FlexShares Blog

What Exactly Is Smart Beta?

Posted by FlexShares on May 11, 2016 8:30:00 AM

The smart beta is actually an umbrella term for investment strategies that utilize alternative methods to construct indexes as opposed to traditional market capitalization weighting. Smart beta emphasizes various investment factors or characteristics in a rules-based and transparent way. Such strategies are often called multifactor investing.


The smart beta concept can be traced back to academic research, specifically the capital asset pricing model created by Bill Sharpe in the 1960’s. Sharpe turned the algebraic equation for a straight line into a market changing theory. His research determined that sensitivity to market volatility in a given security or portfolio, which he labeled beta, explained 70% to 75% of investors’ returns. Alpha, often considered the active return on an investment, gauges the performance of an investment against a market index used as a benchmark, since they are often considered to represent the market’s movement as a whole. The excess return of a fund relative to the return of a benchmark’s index is the fund's alpha. Sharpe posited that the other 25% to 30% were considered alpha.[i]

Expounding on Sharpe’s research, Eugene Fama and Ken French’s seminal work in 1992[ii] found that, while beta was the most explanatory factor, size and value were also important in illuminating portfolio performance. They determined that the level of exposure to value and small capitalization stocks, alongside beta, explained 90% or more of returns, leading to the identification of value and small cap as compensated risk factors. Later in the 1990’s Mark Carhart’s research added a fourth factor[iii], momentum. His research found that when momentum was combined with beta, value and capitalization, at least 95% of returns were explainable.

smart-beta-graph.jpgToday, smart beta strategists apply various multifactor approaches not to explain returns, but rather in an effort to get incremental returns into the portfolio and outperform a market-weighted portfolio over the long term.

[i] Sharpe, William, 1964, “Capital Asset Prices: A Theory of Market Equilibrium under Conditions of Risk,” Journal of Finance, Vol. 47 (2), pp. 427-465.

[ii] Fama, E.F. and French, K.R., 1992, “The Cross-Section of Expected Stock Returns,” Journal of Finance, 22(1), pp. 3–26.

[iii] Carhart, Mark, 1997, “On Persistence in Mutual Fund Performance,” Journal of Finance, 52(1), pp. 57-82.

Before investing, carefully consider the FlexShares investment objectives, risks, charges and expenses. This and other information is in the prospectus, a copy of which may be obtained by visiting www.flexshares.com. Read the prospectus carefully before you invest. Foreside Fund Services, LLC, distributor.

An investment in FlexShares is subject to numerous risks, including possible loss of principal. Fund returns may not match the return of the respective indexes. The Funds are subject to the following principal risks: asset class; commodity; concentration; counterparty; currency; derivatives; dividend; emerging markets; equity securities; fluctuation of yield; foreign securities; geographic; income; industry concentration; inflation-protected securities; interest rate / maturity risk; issuer; management; market; market trading; mid cap stock; natural resources; new funds; non-diversification; passive investment; privatization; small cap stock; tracking error; value investing; and volatility risk. A full description of risks is in the prospectus. 
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