Understanding smart beta

Alternative indexing, fundamental indexing and smart beta are widely used terms to describe indices that break from the traditional market-capitalization approach.

There’s nothing new or wrong with these strategies. They’re often simply a reweighting of an existing market-cap-weighted index, shifting risk exposure and potentially adding what’s known as active risk. They can generally be divided into two broad categories:

<li.Single-factor strategies. These include strategies that are weighted to maximize or optimize exposure to a particular characteristic (factor). The weights may have nothing to do with capitalization.
• Multi-factor market strategies. These include fundamental strategies that seek to weight stocks based not just on size, but also on firm size (employment), book value, cash flow, sales or dividends.

The active fund

The sales pitch for many of these alternative strategies is that market capitalization systematically overweights overvalued and mispriced securities.

If that were true, it should be simple for active managers to outperform their benchmarks. Yet few do so consistently. This is especially clear when results are adjusted for survivorship bias, including funds removed from the public record. The “Mutual fund performance” tables show the performance of actively managed mutual funds versus a representative style benchmark. We see that skilled active managers can add value, but research shows the likelihood of outperformance dwindles over time, as the compounding effect of fees becomes more difficult to surmount.

So, investors considering a rules-based passive strategy face issues similar to those faced by investors who are considering actively managed funds. They should, therefore, evaluate these funds using an active lens.

Read more: Get smart about smart beta>