What is Smart Beta?
When investors talk about indexing, that has traditionally meant something that looks like the S&P 500 index. In recent years, indexing has grown far beyond its traditional roots and it now seems more common for index funds and ETFs to track indexes that look nothing like the S&P 500. Most of these new funds are commonly referred to as "smart beta" funds. It's an ill defined term, but let's explore what it means.
The Traditional Rules
Ignoring the technical details, the two primary characteristics of traditional indexes are:
- Broad coverage of the intended asset class.
- Weighting by size (market cap).
Some of the most popular indexes are constructed this way: the S&P 500, MSCI EAFE, Wilshire 5000, etc. The S&P 500 aims to represent large US companies, so it contains 500 large US companies (Rule #1) and it weights them by market cap (Rule #2).
Breaking the Rules
If all indexes were set up this way, academics and fund companies wouldn't have anything interesting to do. So the obvious solution is to break the rules.
The first approach was to break Rule #1 by targeting ...
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