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.
Today, 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.