Because of the challenging prospects of traditional investment methodologies, some institutional investors are looking for new sources of returns. The author introduces the concept of smart beta—the latest effort by investment practitioners to enhance returns over a passively managed, cap-weighted index.

With cash rates hovering around zero and volatility expected in the equity and fixed-income markets, some investors are looking for unconventional investment methodologies. Traditionally, to access a particular asset class or market, investors could invest either passively in a market-cap-weighted index fund or through an actively managed strategy. Passive options are cheaper but are designed to track, not outperform, a particular market. The active approach is an attempt to outperform the market, but it generally comes with a higher fee. Some fund managers now believe that there is a better way to outperform the market without having to pay active management fees. Their approach is dubbed “smart beta.”

Smart beta practitioners attempt to enhance returns by correcting what they believe is a flawed approach to the passive, cap-weighted methodology. In a cap-weighted index, higher weights are assigned to companies that have experienced relative stock price appreciation and weights are reduced after relative stock price declines. In essence, investors buy high and sell low. Smart beta products are designed to improve returns by providing alternative weighting schematics based on various criteria. To date, there are a number of iterations of the smart beta concept, including an equally weighted schematic, companies weighted by certain financial characteristics, and even companies weighted by volatility. Interestingly, according to researchers at the Cass Business School (2013), these alternative weighting schematic products beat a standard cap-weighted index over the long term, although one study does not provide conclusive evidence of the viability of the methodology.

Although the concept of smart beta is intriguing, investors should remember that there are rarely free lunches in the investment industry; higher returns are often associated with higher risks. These strategies are typically overinvested in smaller-cap, less liquid names, as well as in value companies, which tend to have their own set of problems. Additionally, the assets dedicated to these strategies, although they are growing, are still dwarfed by traditional investment options, so there is no guarantee that these strategies will receive the same support if they underperform the market. Nonetheless, smart beta strategies may be a viable option for investors who are concerned about the construct challenges of traditional market-cap indices and/or the higher fees associated with active managers.