# Unpacking the Smart Beta Strategy: What Investors Need to Know

> **Definition**
>
> Smart beta is a way of investing that combines the benefits of passive investing and the advantages of active investing strategies. It derives from the capital asset pricing model (CAPM) to define the relationship between risk and return. In this model, beta is a measure of volatility or systemic risk of a security compared with the broader market.

## What Is Smart Beta?

Smart beta is a way of investing that combines the benefits of [passive investing](https://www.investopedia.com/terms/p/passiveinvesting.asp) and the advantages of [active investing](https://www.investopedia.com/terms/a/activeinvesting.asp) strategies. 

Smart beta derives from the [capital asset pricing model (CAPM)](https://www.investopedia.com/terms/c/capm.asp), developed in an attempt to define the relationship between risk and return. As part of this model, [beta](https://www.investopedia.com/terms/b/beta.asp) is a measure of volatility or systemic risk of a security compared with the broader market. Over time, economists have elaborated on CAPM to explore a number of other factor premiums—factors like momentum and growth that can help to better explain and predict the relationship between risk and expected return. 

### Key Takeaways

*   Smart beta seeks to combine the benefits of passive investing and the advantages of active investing strategies.
*   Smart beta uses alternative index construction rules to traditional market capitalization-based indices.
*   Smart beta emphasizes capturing investment factors or market inefficiencies in a rules-based and transparent way.
*   Smart beta strategies may use alternative weighting schemes such as volatility, liquidity, quality, value, size, and momentum.
*   As of February 2024, smart beta ETFs managed roughly $1.56 trillion in combined assets.

## What Are Smart Beta Strategies?

So-called “smart” beta strategies aim to obtain [alpha](https://www.investopedia.com/terms/a/alpha.asp) by utilizing these factors in the creation of alternative indices separated out from traditional [market capitalization](https://www.investopedia.com/terms/m/marketcapitalization.asp)\-based indices. This approach seeks the best construction of an optimally diversified portfolio. In effect, smart beta is a combination of [efficient market hypothesis](https://www.investopedia.com/terms/e/efficientmarkethypothesis.asp) and value investing. 

One complaint smart beta investors have about market-cap-weighted indices is that they effectively prioritize yesterday’s stock winners (those companies that have already grown to have larger capitalizations). The smart beta investment approach applies to popular asset classes, such as equities, fixed income, commodities, and multi-asset classes. 

### Note

Perhaps most commonly, smart beta strategies are employed by exchange-traded funds (ETFs).

## How Smart Beta Works

Smart beta defines a set of investment strategies that emphasize the use of index construction rules differing from those based on market capitalization weighting. These strategies emphasize capturing investment factors or [market inefficiencies](https://www.investopedia.com/terms/i/inefficientmarket.asp) in a rules-based and transparent way. The increased popularity of this approach is linked to a desire for portfolio risk management and diversification along factor dimensions, as well as seeking to enhance [risk-adjusted returns](https://www.investopedia.com/terms/r/riskadjustedreturn.asp) above cap-weighted indices.

Smart beta strategies seek to passively follow indices, while also considering alternative weighting schemes such as [volatility](https://www.investopedia.com/terms/v/volatility.asp), liquidity, quality, value, size, and momentum. These funds don’t track standard indices, such as the [S&P 500](https://www.investopedia.com/terms/s/sp500.asp) or the Nasdaq 100 Index, but instead focus on areas of the market that offer an opportunity for exploitation. 

Some of the most common areas of focus for smart beta ETFs include:

*   Volatility (with funds tracking an index of low-volatility securities, for example)
*   [Momentum](https://www.investopedia.com/terms/m/momentum.asp) (in which stocks are weighted within an index based on their price momentum over a specified period)
*   Equal-weighting (in which an index is rebalanced to provide equal weight to each constituent, rather than prioritizing those with larger market caps)

## Selecting Smart Beta Strategies

Smart beta is a broad term encompassing a range of investment products focused on custom-built indices aiming to outperform a sector or the broader market. There are a wide variety of options from which to choose and no single approach for every investor. 

Some fund managers are prescriptive in identifying smart beta ideas that are value-creating and economically intuitive. Equity smart beta seeks to address inefficiencies created by market-capitalization-weighted [benchmarks](https://www.investopedia.com/terms/b/benchmark.asp). Funds may take a thematic approach to manage this risk by focusing on mispricing created by investors seeking short-term gains, for example.

Managers may also choose to create or follow an index that weights investments according to fundamentals, such as [earnings](https://www.investopedia.com/terms/e/earnings.asp) or book value, rather than market capitalization.

Alternatively, managers may use a risk-weighted approach to smart beta that involves the establishment of an index based on assumptions of future volatility. For instance, this may involve an analysis of historical performance and the [correlation](https://www.investopedia.com/terms/c/correlation.asp) between an investment's risk relative to its return. The manager must evaluate how many assumptions they are willing to build into the index and can approach the index by assuming a combination of different correlations.

### Smart Beta Popularity

Although smart beta funds typically attract higher fees than their vanilla counterparts, they continue to remain popular with investors. As of October 2024, there were approximately 1,041 [smart beta ETFs](https://www.investopedia.com/terms/s/smart-beta-etf.asp) trading in the U.S. In total, smart-beta funds commanded some $1.56 trillion in total cumulative assets, up from $616 billion in 2016.

## Examples of Smart Beta Funds

The following three ETFs each use a different smart beta strategy seeking value, growth, and dividend appreciation, respectively:

The **Vanguard Value Index Fund ETF Shares ETF** ([VTV](https://www.investopedia.com/markets/quote?tvwidgetsymbol=vtv)) tracks the CRSP US Large Cap Value Index. Its benchmark determines value using several fundamental ratios including price-to-book (P/B), [forward price-to-earnings](https://www.investopedia.com/terms/f/forwardpe.asp) (forward P/E), historical P/E, dividend-to-price, and [price-to-sales](https://www.investopedia.com/articles/fundamental/03/032603.asp). The fund has $132.1 billion in assets under management (AUM) as of January 2025.

With net assets of $105 billion as of January 2025, the **iShares Russell 1000 Growth ETF** ([IWF](https://www.investopedia.com/markets/quote?tvwidgetsymbol=iwf)) seeks to provide similar returns to the Russell 1000 Growth Index. The underlying index selects components based on three fundamental factors: [price-to-book](https://www.investopedia.com/terms/p/price-to-bookratio.asp), medium-term growth forecasts, and [](https://www.investopedia.com/terms/s/salespershare.asp)sales-per-share growth.

The **Vanguard Dividend Appreciation Index Fund ETF Shares** ([VIG](https://www.investopedia.com/markets/quote?tvwidgetsymbol=vig)) aims to return similar investment results to the Nasdaq US Dividend Achievers Select Index. The fund selects firms that have increased their [dividend payments](https://www.investopedia.com/ask/answers/102714/how-and-when-are-stock-dividends-paid-out.asp) for the past 10 years and market-cap-weights its holdings. As of January 2025, VIG has AUM of $87.8 billion.

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>
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## The Bottom Line

Smart beta makes use of factors—characteristics like value or quality that investors believe will cause securities to outperform the broader market—to construct indices that differ from traditional market capitalization-weighted indices. While these indices are alternatives to traditional sector- or market-wide collections of securities, smart beta ETFs that track them are still passively managed. This is one reason why smart beta is considered to be an approach to investing that is between active and passive in terms of strategy.

> **Article Sources**
>
> 1.  Fama, Eugene F. and Kenneth R. French. "[A Five-Factor Asset Pricing Model](https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2287202)," Fama-Miller Working Paper, Available at SSRN.  
>     
> 2.  ETFGI. "[ETFGI Reports Assets of US$1.56 Trillion Are Invested in Smart Beta ETFs Listed Globally at the End of February](https://etfgi.com/news/press-releases/2024/03/etfgi-reports-assets-us156-trillion-are-invested-smart-beta-etfs-listed)." 
>     
> 3.  iShares. "[Smart Beta 101: The Basics and Its Role in Portfolios](https://www.ishares.com/us/investor-education/investment-strategies/what-is-smart-beta)." 
>     
> 4.  Investor.gov. "[Smart Beta, Quant Funds and Other Non-Traditional Index Funds](https://www.investor.gov/introduction-investing/investing-basics/investment-products/mutual-funds-and-exchange-traded-3)."
>     
> 5.  Statista. "[Largest Smart Beta Exchange Traded Funds (ETFs) Traded in the United States as of October 11, 2024 by Assets Under Management](https://www.statista.com/statistics/1199383/largest-smart-beta-etfs-traded-usa/)."
>     
> 6.  VettaFi. "[VTV Vanguard Value ETF](https://etfdb.com/etf/VTV/#etf-ticker-profile)." 
>     
> 7.  VettaFi. "[IWF iShares Russell 1000 Growth ETF](https://etfdb.com/etf/IWF/#etf-ticker-profile)." 
>     
> 8.  VettaFi. "[Vanguard Dividend Appreciation ETF](https://etfdb.com/etf/VIG/#etf-ticker-profile)."