Smart beta refers to investment in portfolios, being a combination of both passive and active investing. The smart beta approach is an arguably perfect intersection between traditional value investing and the efficient market hypothesis.
A smart beta portfolio is efficient because it tracks with an underlying index and is optimized using the same techniques that active portfolio managers utilize. It allows a passive approach to discover the most optimal investment opportunities and combines it with the active involvement of skilled managers.
History of Smart Beta
The smart beta approach was initially theorized through Modern Portfolio Theory (MPT) by American economist Harry Markowitz. MPT, at its core, asks the best ways to develop a portfolio that is diversified in an optimal way. Smart beta answers the basic question of diversification by enabling a portfolio to grow along both active and passive lines.
How It Works
The primary objective of the approach is to acquire one of three things (or a combination of them):
Smart beta is applied to asset classes with a substantial amount of popularity, which includes (but isn’t limited to) commodities, equities, fixed income, and multi-asset classes.
The approach essentially outlines a collection of strategies for investments that highlight alternative index building guidelines, emphasizing ways to capitalize on market inefficiencies in a concise way. It inevitably leads to a diverse portfolio with lower risks than what traditional investing provides. The strategies involve still passively follow indices but take things like value, liquidity, quality, and momentum into consideration.
Smart beta is, ideally, the best of passive and active investment strategies. Every smart beta strategy follows defined and transparent rules, the same as any typical index-following strategy would. The primary difference is that the former strategy focuses on areas within the market that are ripe for exploitation.
There are multiple smart beta strategies for portfolio managers to choose from. Some may opt to follow or construct an index that gives weights to investments based on fundamental characteristics instead of market capitalization.
The approach depends entirely on the portfolio manager’s or client’s needs. Another option is to pursue a risk-weighted approach. The risk-weighted approach involves the creation of an index that is based entirely on how volatile the market is projected to be in the future. For example, a manager may analyze an investment’s track record of performance and use the information to determine how it correlates to possible future performance and risk.
CFI is the official provider of the global Financial Modeling & Valuation Analyst (FMVA)™ certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional resources below will be useful:
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