Smart beta funds aim to combine the best aspects of passive and active management, aiming to beat the index by eliminating any element of discretionary human judgement.
Finance theory divides investment returns into two parts: “alpha” is the value added through the decisions made by you (or the manager of the fund you hold); “beta” is the return that results from the overall market.
Assume that a portfolio of investments goes up by 15% while the overall market rises 10%. In this case, beta is 10% and alpha is 5% (15%–10%). In reality, the calculation is a bit more complicated because it depends on whether the type of stocks in the portfolio would be expected to fluctuate more than the overall market, but this demonstrates the idea. Beta is what you get from simply being invested in the market (ie, what a passive index investor gets); alpha is what an investor gains or loses from active investment management.
Smart beta strategies lie between active and passive investing. A smart beta fund tracks an index, but with that index constructed differently to a traditional stockmarket index. Instead of weighting securities by size, a smart beta index selects or weights according to characteristics that may make them more likely to outperform the wider market. Common characteristics (often called factors) include variations on size (historically, small stocks tend to outperform larger ones on average); value (stocks that seemed cheap on metrics such as price/earnings or price/book have tended to outperform expensive ones); volatility (less volatile stocks have tended to do better); momentum (stocks that are rising strongly may be more likely to keep rising); and quality (profitable, efficient business with less debt have tended to beat weaker ones).
Advocates of smart beta say that it can deliver higher returns than passive investing in a cheaper and more systematic way than active investing. This makes sense in principle, but depends on the continued success of the factors chosen for the smart beta strategy. There can be no certainty that a factor that worked in the past will keep doing so.