What “Smart Beta” Means to Us

Key Points

  • The absence of a generally accepted definition of “smart beta” has given people license to describe a wide range of products as smart beta strategies.

  • In equity investing, we use smart beta to refer to valuation-indifferent strategies that break the link between the price of an asset and its weight in the portfolio while retaining most of the positive attributes of passive indexing.

  • By sharing our thoughts about the term, we hope to guide the discussion towards the real issue: how best to manage investor assets.

As with most new expressions, “smart beta” is in the process of seeking an established meaning. It is fast becoming one of the most overused, ill-defined, and controversial terms in the modern financial lexicon. Unfortunately, the success of so-called smart beta products has attracted a host of new entrants purporting to be smart beta products when, frankly, they aren’t! They stretch the definition of smart beta to encompass their products, a natural business strategy. Without a simple, generally accepted meaning, the term “smart beta” risks becoming meaningless.

Is that a bad thing? Probably not to the critics of the term smart beta. These are mainly the definitional purists. Bill Sharpe, who coined and defined “alpha” and “beta” in his seminal work (1964), famously remarked that the term makes him “definitionally sick.” His objection is completely legitimate: Bill defined beta as merely a measure of the non-diversifiable risk of a portfolio, measured against the capitalization-weighted market, and defined alpha as the residual return that’s not attributable to the beta. Some providers of traditional cap-weighted indices similarly object, either because they believed that there is only one “true” beta or because they infer from the smart beta label that its advocates believe that cap weighting is “stupid beta.”