Traditionally, indices are constructed using the market‐cap‐weighted method. The theoretical foundation for market‐cap‐weighted indices as a basis for investment lies in the Capital Asset Pricing Model (CAPM) and the Efficient Market Hypothesis. In practice, market‐cap‐weighted indices have become the mainstream basis for passive investment because of the perceived benefits, such as self‐rebalancing, low turnover, and low transaction costs. However, due to the embedded link between stock weights and stock prices, market–cap‐weighted strategies could be more vulnerable to price bubbles, such as the late 1990s technology bubble and the 2007 financial bubble in the U.S.
The bitterness experienced during the market crash of the early 2000s led to an indexing innovation that goes beyond CAPM. As a result, we have witnessed a growing interest and proliferation of alternate beta or smart beta strategies that provide investors with alternative sources of risk and return, other than traditional market beta, yet in a passive and cost‐efficient way.
Collectively, index strategies that use non‐market‐cap‐weighted methods are referred to as alternate beta strategies. Since many of them can provide positive excess returns over the long term, they are also called smart beta strategies. Although different in stock selection and weighting methods, alternate beta strategies generally attempt to provide explicit or implicit exposure to one or a set of systematic risk factors apart from the market beta.
Since the introduction of alternate beta ETFs in 2005 in the U.S., we have seen the expansion of alternate beta strategies, especially in the U.S. and European ETP markets. Within these markets, the most popular and wellknown categories are dividend, low‐volatility or minimum variance, equally weighted, and fundamentally weighted strategies.
Factor‐based strategies make up a subcategory of alternate beta strategies that are explicitly constructed to capture specific factors. In recent years, single‐factor strategies have gained traction in the investment community, as they provide a new way of diversification along risk‐factor dimensions instead of traditional asset classes (see Exhibit 1). The distinct risk/return characteristics of each single factor, and often the low correlation among factors, make them a powerful toolkit for strategy implementation, and they helped give rise to innovative investment notions, such as factor rotation and factor timing.