There has been a lot of talk recently about smart beta —and some of you may be wondering what it is. First, let’s take a quick look at what defines “beta.”
Beta is a measurement of the volatility of an investment compared to the market. An investment with a beta of 1 is, in theory, delivering the same volatility and performance experience as the market.
Consider that the majority of indexes dominating the investment landscape tend to be market capitalization-weighted (and remember that you cannot invest directly in an index). The very first exchange-traded funds (ETFs)—and the majority of those that followed—were created as a way to get the “index” investment experience. Since these capitalization-weighted indexes are considered “the market,” the ETFs that passively mirror them are considered “beta,” as their goal is to track the performance of indexes that are themselves designed to measure the performance experience of “the market.”
So, you may be wondering, if market capitalization-weighted ETFs are beta, what is smart beta?
Some define smart beta as simply any type of index that is not market capitalization-weighted. Others may define it as investments that apply unique screens or alternative weighting methodologies to existing indexes. In our opinion, the smart beta approaches attracting the greatest attention include:
• Equal-Weighted Indexes: Components are often selected from established indexes such as the S&P 500 Index, but are equally weighted so that all components have identical weights when rebalanced.
• Fundamentally Weighted Indexes: Components are selected to provide broad exposure to an equity market
based on market capitalization, but companies are weighted by a fundamental factor such as aggregate dividends or earnings.