Smart beta indexes are typically designed to address a specific objective like excess return generation, mitigation of volatility or increasing diversification. As we can see in the table below, some key things to consider when choosing between a more traditional cap-weighted approach and a smart beta methodology are the differences in simplicity and transparency, cost, liquidity and capacity, and governance.
Two of the simplest smart beta index construction methodologies are equal weighting and fundamental weighting. Both use characteristics other than market value in their construction. An equally weighted index aims to address the inherent concentration bias within a cap-weighted index by applying an equal weight to both sectors and constituent companies. The fundamental approach seeks to address the potential valuation concerns of a cap-weighted index by using a company’s fundamental measures —such as sales, operating cash flow, dividends and book value—to determine its weight in the index.
Both the equal weighting and fundamental weighting methodologies are highly intuitive. The equally weighted index uses the universe of stocks from its cap-weighted counterpart and then applies an equal weight to each sector and then to each stock within its sector. This results in an index that is more evenly distributed among both sectors and companies than a cap-weighted index.
The fundamental weighting approach uses the universe of stocks from its cap-weighted counterpart and reweights the constituent companies according to the average of three fundamental factors. Some market participants believe that fundamental measures are a better gauge for the true value of a company. Instead of using market price, the companies in a fundamentally weighted index are ranked and weighted using the five-year average of adjusted sales, retained operating cash flow and dividends and buy backs. The result is an index that avoids adding overvalued stocks while potentially including undervalued stocks—an inherent contrarian trading approach.
Just because these alternative weighting methodologies are denoted using a Greek letter does not mean they are overly complex. As we have seen, some smart beta indexes are more simply and intuitively constructed than their cap-weighted counterparts. Market participants who might have shied away from them in the past might be interested to take a second look.
The second part of this blog series will take a closer look at how these two simple smart beta methodologies have fared relative to their cap-weighted counterpart. Please also see our report, "The intuitive foundations of smart beta," for a more detailed discussion of the intuitive nature of smart beta indexes.
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