Smart Beta: The Owner’s Manual

Abstract

Smart-beta products have captured the interest of investors. But where do they fit in their portfolios? The typical investor, who currently owns active and index products, should own active, index, and smart-beta products. This article introduces a framework that decomposes any strategy’s return over time into a broad capitalization-weighted index return, the return to static exposures to smart-beta factors, the return to timing smart-beta factors, and the return above and beyond smart beta. Smart-beta risk constitutes roughly one-third of the active risk of an average active equity manager, and roughly two-thirds of the active risk of an average fixed-income manager. Diversifying across active managers increases the fraction in smart beta. Most investors will want all of these return sources in their portfolio, and this framework facilitates optimizing the blend.