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What is Smart Beta Investing?

Smart beta is a relatively new term in investment management, but the concept has been around for decades.  It is a type of factor investing, a strategy in which the securities are chosen based on attributes that are associated with higher returns, which uses different rules of portfolio construction than traditional asset class investment.  The idea of smart beta is to potentially add value to a portfolio by systematically selecting alternative weightings and portfolio holdings in a way that deviates from the manner in which traditional market capitalization based indices have been created. Regular rebalancing is also part of this strategy. Rebalancing is a process in which the original weighting in the portfolio is realigned.

Smart beta’s origins are rooted in academia.  Researchers discovered that there were market inefficiencies when constructing a portfolio strictly based upon price.  The identification of these inefficiencies spawned factor investing.  Although they did not realize they were early pioneers of factor investing, Graham and Dodd identified the first known factor back in 1934, value.  Since that time, many additional factors have been recognised, including market, value, size, momentum, low volatility, term, credit, etc.

Why is it important to identify these factors?  Due to the growing level of correlation amongst global asset classes, it has become important to find areas for investment that won’t be affected in the same way by movements in the general market.  Factor-based investments have always sought to probabilistically increase risk-and-return outcomes, provide greater transparency and increase control with lower costs.

So how does one go about implementing a smart beta or factor-based investment portfolio?  From a retail investor’s perspective, the first step is to begin with a market-cap weighted index.  Some well-known examples include the S&P 500 in the US, the FTSE 100 in the UK or the Hang Seng Index in Hong Kong.  Next, one has to apply weights or slants to the specific factors (e.g., size, value, market or quality) which the investment manager believes will help the retail investor achieve outsized returns and manage portfolio risk.  The investor will see the traditional market-cap based portion of the portfolio along with the segment which includes the factor stratification, which ultimately builds the portfolio out and provides a focus on those areas being exploited.

If you’re interested in learning more about this, consider working with a firm that adopts this type of investment approach.


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