Smart beta strategy

A smart beta investment strategy, also referred to as an active beta strategy or strategic beta strategy, is a strategy that uses more sophisticated portfolio weighting approaches or which tries to exploit an asset pricing anomaly. On this page, we provide a smart beta definition, give some examples of smart beta strategies and smart beta weighting approaches, and explain some of the advantages of smart beta strategies.

Smart beta strategy definition

What is the definition of smart beta? There are two broad categories of smart beta. On the one hand, there are the smart beta strategies that try to exploit an anomaly. For example, a lot of smart beta strategies try to exploit the low volatility anomaly. Other typical examples of smart beta strategies are the strategies that try to exploit the size effect, (cross-sectional) momentum in stocks, or the low beta anomaly. The latter strategy only invests in low beta stocks. These strategies are all related in that they all try to exploit risk factors that have been documented by academia. That is why these strategies are also referred to as risk factor investing.

The other broad category of smart beta strategies is the set of strategies that applies a different weighting scheme. The most famous example is the equal weighting case. In this case, the market index (for example the S&P 500) is taken, but instead of market capitalization weight, the manager applies equal-weighting. This will overweight the smaller stocks, at the expense of the larger companies’ stocks.

Advantages of smart beta strategies

The advantage of smart beta strategies is that the returns from strategies are less correlated with stocks than other strategies. This may provide investors with diversification benefits, thereby smoothing the performance of the portfolio.

Disadvantages of smart beta strategies

The disadvantage of smart beta strategies is that the anomaly on which the strategy is based may not perform equally well going forward. For example, it can be that the mispricing on which the strategy is based disappears. In that case, the performance may be disappointing. As the adage goes, past performance is not necessarily indicative of future results.

Summary

The approaches we discussed above try to generate excess returns by exploiting well-known anomalies. The result may be smart alpha. That is, an abnormal return that allows investors to beat the market. The low volatility anomaly is an example of a smart beta strategy.

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