Investors Increasingly Drawn To Smart Beta 1

Last Updated: 21 March 2023

Exchange-traded funds based on alternative indices have been growing in popularity in recent years, and issuers have launched a range of so-called “smart beta” products to meet the increasing investor demand. But there’s still plenty of room for growth, according to the Edhec-Risk Institute. In its 2011 European ETF survey, released earlier this week, it reported that 39 per cent of survey respondents said that they would like to see more ETFs based on alternative indices, up from 29 per cent in last year’s survey.

Alternative indices have appeared in many guises, from accessing new asset classes through to factor or risk premia-based indices. However it is smart beta, a reassessment of how to weight existing assets to produce more efficient investments, that is capturing the attention of investors in Europe and worldwide.

To understand the rationale behind the various new approaches devised by ETF and index providers to respond to the growing demand from investors, it is useful to first consider the criticisms of traditional market capitalisation-based benchmarks. Market-weighted indices are an attempt to index a market portfolio and therefore, according to the Capital Asset Pricing Model (CAPM), should approximate to the “beta” of the market.

According to the CAPM, a key tenet of modern portfolio theory, the market portfolio should be optimal in terms of the investment return per unit of risk. Much of the academic criticism of this theory has centered on its failure to produce the most efficient portfolio, but there are also more down-to-earth criticisms, for example that market weights have an inbuilt size bias that often produces portfolios that are heavily concentrated on specific sectors. Also, because assets with higher valuations have a higher weighting in the market portfolio, these benchmarks are more vulnerable to asset price bubbles and subsequent corrections.

Alternatives to market capitalisation-weighting have tended to sit in one of three camps: de-concentration or equal weighting, risk-based weighting and fundamentally-weighted indexing.

European Smart Beta ETFs
Equally Weighted Fundamental
Ossiam ETF Stoxx Europe 600 Equal Weight NR Lyxor FTSE RAFI Europe
Ossiam ETF Euro Stoxx 50 Equal Weight NR Lyxor FTSE RAFI US 1000
Ossiam ETF CAC 40 Equal Weight NR PowerShares FTSE RAFI All-World 3000 Fund
Think Global Equity Tracker PowerShares FTSE RAFI Asia Pacific Ex-Japan Fund
Think Global Real Estate Tracker PowerShares FTSE RAFI Developed Europe Mid-Small Fund
db X-trackers S&P 500 Equal Weight PowerShares FTSE RAFI Developed 1000 Fund
PowerShares FTSE RAFI Emerging Markets Fund
Risk Weighted PowerShares FTSE RAFI Europe Fund
Ossiam ETF iStoxx Europe Minimum Variance NR PowerShares FTSE RAFI Hong Kong China Fund
Ossiam ETF US Minimum Variance NR PowerShares FTSE RAFI UK 100 Fund
Ossiam ETF FTSE 100 Minimum Variance PowerShares FTSE RAFI US 1000 Fund
Ossiam ETF Emerging Markets Minimum Variance NR PowerShares FTSE RAFI Italy 30 Fund
PowerShares FTSE RAFI Switzerland Fund
Pimco EM Advantage Local Bond Index Source ETF
Pimco European Advantage Govt Bond Index Source ETF

Sources: Company websites,

Equal Weighting

The simplest way to avoid a size bias is to give equal weight to every asset in the portfolio. In an equally-weighted index, the return is simply the arithmetic average of the returns of its constituents. To maintain equal weight it is important that these indices are periodically rebalanced and provided this is done, equal weighting avoids the worst effects of asset pricing bubbles.

In the US, Rydex pioneered equally-weighted ETFs with the Rydex S&P 500 Equal Weight ETF and it now has 17 ETFs covering a variety of equally-weighted US and international equity benchmarks and sectors. In Europe, the idea has taken longer to catch on, but Deutsche Bank, ThinkCapital and Ossiam all launched equally-weighted ETFs in 2011. Despite its simple appeal, equal asset weighting can still show significant sector biases. This is because it is still based on the distribution of the underlying assets, which may be skewed.

Investors unwilling to completely abandon market weights can also take steps to limit concentration by overlaying one or more weight caps on top of existing benchmark weights. Weight caps can be applied to individual assets, sectors or other sets of related assets.

Bond investors, for example, often use capped benchmarks. Alex Claringbull, senior fixed income portfolio manager at iShares, says that when selecting a benchmark for any new fund, for example the iShares Markit iBoxx $ High Yield Capped Bond ETF, iShares will look at the index weights and, where appropriate, work with the index provider to de-concentrate exposure. “An index is a theoretical target and we have the ability to research and track how they perform. In the high yield market we typically have a market cap of 3 percent for all bonds from any single issuer to avoid over concentration of risk.”

  • Luke Handt

    Hello, my name is Luke Handt; I am a successful Bitcoin trader, financial analyst, and researcher. I have been studying the market trends for the conventional stock exchange system globally since I was in college.

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