An Investor’s Guide to Smart Beta Strategies
Over the last five years, investors witnessed the emergence of a new class of equity index products known as strategy indexes, or smart betas.
Smart betas have two distinct features: First, they advocate against traditional capitalization weighting; second, they are based on relatively transparent quantitative methodologies. Whether based on empirical research or actual live history, these smart beta products do seem to offer superior performances relative to traditional indexes, substantiating the claim that cap weighting might be a suboptimal index construct. The transparency mitigates the information asymmetry problems between investors and managers, which reduces ongoing due diligence costs.
In this article, we discuss the advantages of smart betas relative to active management and traditional indexes. We also examine three of the most popular smart beta products. Additionally, in light of the increased investor interest in low-risk strategies following the 2008 financial crisis, we specifically provide an allocation framework for investors who may have different preferences for high Sharpe ratio (higher risk-adjusted return) versus high information ratio (more consistent outperformance over a benchmark such as the S&P 500 index).
Why Smart Beta?
Having experienced the Japanese bubble in the late 1980s and the dot-com bubble in the early 2000s, many investors have become acutely aware