The market for smart beta has soared over the past few years despite confusion over names and definitions. Part 1 of a 5-part Special Report on Smart Beta.

Smart beta investing has quickly gained attention over the past few years -- but what exactly is it?

The industry would traditionally understand smart beta to be investments combining active and passive strategies to drive alpha (returns) and lower beta (risk), at a lower cost than possible with active managers. But smart beta’s open infrastructure means different people have different interpretations of what it truly is.

For Martin Raab, co-author of Wiley’s "Beyond Smart Beta," the industry standard definition doesn’t cut the mustard. He says the concept actually refers to investments that optimize an existing index investment framework for better performance and less risk. Chris Brightman, CIO of Research Affiliates, gives a slightly different definition – simple, low-cost investment strategies made based on good research on sustainable sources of excess returns.

Not only can smart beta have different definitions, it can even have different names.

Asset managers offering smart beta will call the strategy by different names depending on how they want to market it and how they recommend its use in a financial plan, Raab says. Some smart beta providers think if their fund is too similar to an offering from one of their peers, they will simply give it a different name to distinguish it, he says.

Yet despite its many names and interpretations, experts all express a similar underlying understanding of smart beta investing as a strategy.

Put simply, it’s an attempt to marry the best parts of active and passive portfolio construction by applying active filters to passive investments, Morningstar director of global ETF and passive strategies research Ben Johnson says. For advisors seeking to drive returns, smart beta may be applied using a fundamental index strategy, Brightman says. For instance, Research Affiliates uses fundamental indices to drive returns by selling outperforming companies and buying underperforming companies, he says. And with smart beta they can filter each group to better know which to buy and sell.

Smart beta can also be used to mitigate risk. One way of doing so is combining smart beta factors with index investments to add diversity. And experts say the lack of diversity in some index funds may require this smart beta diversification approach. Why the need for diversity in modern portfolios, which should by design already be diverse? As of August 2018, Apple, Microsoft, Amazon, and Facebook make up more than 10% of the S&P 500 index, CNBC reports -- which means a U.S. Equities index that contains these stocks and is supposed to be diverse by design, may not actually be as diverse as it seems. So, advisors using a smart beta strategy could filter out technology companies to create a more diversified investment that has lower exposure to Apple, Microsoft, Amazon, or Facebook stocks, says Mike Genovese, founding partner of Genovese Burford & Brothers.

Ben Johnson

But smart beta investments don’t have to just be used with index investments or ETFs. These strategies can use a wide variety of investment vehicles. The instruments can be constructed as separate accounts, mutual funds, and other vehicles, both Johnson and Raab say. As such, smart beta’s malleability may be contributing to its growth in popularity, although there are also several other important factors.

For one, investors and advisors seek out smart beta investments simply because they can be a substitute for traditional active management, Raab says. He claims smart beta is in some ways an improvement on traditional active management. As a hybrid, smart beta inherits traits from its passive parent in that it is a form of rules-based investing – and the rules used to govern smart beta instruments tend to be transparent, Raab says. In layman’s terms, smart beta does what it says it does.

Johnson says another distinction between smart beta and traditional active management is important to its growing popularity: Quite simply, smart beta investments “tend to be less costly.”

Exposure to smart beta is a cost-effective way to gain exposure to the broader market, Doug Regan, CEO of $3 billion RIA Cresset Wealth Advisors, says. Fees have become a bigger deal to clients, who are becoming wiser to the allocation of their fee dollars. Advisors can capitalize on inefficiencies in the active management market, use active management where needed, and let smart beta handle the rest at a lower cost, he says.

Smart beta offers a cost-effective way to gain exposure to efficient markets and is increasingly appealing to all types of investors, says Regan.

Brightman also agrees active management is more expensive:

Dissatisfaction with underperforming active managers is also a reason investors and advisors increasingly use smart beta, Brightman says. A Morningstar "Active/Passive Barometer" report reveals 43% of active managers beat their passive peers in 2017, but only 26% of active managers were able to achieve that feat in 2016. And despite the improvement of active versus passive fund managers from 2016 to 2017, actively managed funds have failed to beat their benchmarks over longer-term horizons, the report says. Such figures mean your chance of finding a market-beating active manager is far less than a coin toss.

Broker dealers and RIAs are increasingly reviewing whether smart beta can be used to drive overall portfolio returns and because of that interest, the strategies are “highly en vogue,” Raabs says. The strategy has also been promoted by large ETF issuers like JPMorgan and WisdomTree.

Morningstar data reveals smart beta investments are enjoying significant growth.

Over the past three years the market size of smart beta investments has increased by over $400 billion from $500 billion to near $1 trillion, data shows. Included in the total growth observed by Morningstar is the steady increase of the investment’s growth rate of 20% from 2015 to 2017. Data also reveal two specific smart beta strategies identified by Morningstar have steadily grown in popularity: return-oriented and risk-oriented strategies. Return-oriented smart beta strategies aimed at building investment returns increased in use from December 2014 through August 2018, growing from a market size of about $460 billion to almost $900 billion. Risk-oriented smart beta strategies also grew from a market size of $15 billion to $60 billion over the same period.

Smart beta is clearly surging in popularity industry-wide, but experts say advisors may turn to the investment for different reasons.

Next: How Does Smart Beta Fit High Net Worth Client Portfolios?