A market-capitalization-weighted index provides clients with exposure to a particular market based on security prices, without considering any true company fundamental to judge its value. However, the Great Recession of 2008 roiled investors with deep declines that they were not anticipating, as a result of overexposure to potentially overpriced stocks relative to their true value.

As such, things began to change, with many financial advisors shifting to smart beta strategies in the past 10 years. Head of Beta Solutions at OppenheimerFunds, Sharon French, is all too familiar with the evolution of indexing, particularly in the past decade.

“As much as indexation and buying a broad-based index has its merits, you need a little more reinforcement on the risk side,” said French.

Why Smart Beta Makes Sense in Today’s Environment

Given certain market conditions, investors need more than just a passive index that goes beyond a one-size-fits-all template that uses market cap weighting. While these indexes provided simple, low-cost solutions, particularly during the recovery after the Great Recession of 2008, and the recent bull run that saw the major indexes reach historic highs, the need for even greater scrutiny was necessary in the quest for more alpha —a case for smart beta.

In terms of defining smart beta, one may think of these strategies as passive strategies with an active element. Smart beta strategies aim to deliver returns using a rules-based and fully transparent approach to investing in the securities of a particular market index.

The potential benefits an investor can reap using a smart beta approach becomes fully apparent when considering that a market-cap-weighted index does not allow for favorable tilts toward any factors that have historically driven equity returns.

Applications for Smart Beta Today

Furthermore, October’s volatility was another reminder that just because investors were the beneficiaries of a decade-long bull run, it doesn’t mean the same strategies can still apply going forward, and that investors need to focus their attention to smart beta strategies. French mentioned three factors that will further necessitate the need for smart beta strategies: performance/diversification, risk management, and fees.

Through smart beta, investors get adaptable exposure with the rules-based approach in conjunction with reaping the rewards of diversification via access to a broad market index. In addition, the simplicity of buying a broad-based market index has a concentration of risk, and should a market correction ensue comparable to that witnessed in the fourth quarter, investors are left vulnerable.

As such, investors are willing to pay more for the supplemental benefits smart beta can provide, such as downside risk mitigation.

“I think that people are willing to pay for an active component, where you’re programming in a certain approach in a rules-based fashion,” noted French.

OppenheimerFunds believes that one fundamental approach–revenue weighting–is of particular benefit since it provides exposure to a broad basket of securities while weighting them by revenue, rather than market capitalization. Revenue weighting has historically been a truer indicator of a company’s value, and eliminates the exposure to overvalued stocks based on investor sentiment as with market capitalization weighting.