An index strategy that aims for a better risk-return ratio than the traditional market-capitalization weighted index. 'Smart beta' refers to the higher expected index performance, in terms of risk and return.
The smart-beta strategy is an alternative index strategy for investing in a market-cap-weighted index, since the market-cap-weighted approach has a number of constraints for investors. For instance, most of the money flows into stocks with the highest valuation. This means that investments are made counter to the Value factor, which focuses on selecting stocks with a lower valuation.
Just like factor investing, smart beta strives to create an improved risk-return ratio. An important aspect is that smart-beta strategies are not passively, but actively managed. Examples of smart-beta strategies are equally weighted equity strategies or low-volatility strategies.
Although smart-beta factor approaches have proven capable of using factor premiums, there are a number of pitfalls. Taking unrewarded risk is an example, as are taking on higher transaction costs and the negative effects of other factors.
Also read: How Smart is 'Smart Beta' Investing?