Insights

The intuitive foundations

of smart beta

1
Nearly half of global asset owners are now investing in smart beta , with interest continuing to rise year-
over-year. The term smart beta encompasses an increasing variety of strategies, with many new smart
beta products being launched each month around the world. Smart beta products typically aim to replicate
indexes that embed the strategies underlying methodologies.
Although some newer index approaches rely on detailed quantitative modelling, smart beta indexing
doesnt have to be associated with complexity. In this Insights, we focus on some smart beta index
construction approaches that follow relatively simple, intuitive weighting schemes. And, regardless of their
methodology, all FTSE Russell smart beta indexes follow transparent, consistent rules in order to achieve
the stated index objectives.

Smart beta in context

An increasing number of investors worldwide are using index-based approaches to construct and manage
2
their portfolios. The objective of a manager of an index-based (or passive ) investment portfolio is to
replicate the indexs return, before fees and costs.
3
According to a 2017 report by Moodys Investor Services, passive investments now account for US$6
trillion of assets globally and 29 percent of assets under management (AUM) in the US. Moodys predicts
that the continuing adoption of index-based investment products will lead to passive funds market shares
in the US exceeding 50 percent by early in the next decade.

1
Source: FTSE Russell, Smart Beta: 2017 global survey findings from asset owners.
2
Passive, index-based portfolios are passive in implementation, but still require some activity, for example when the index changes as a
result of a rebalancing or due to corporate actions such as dividends, mergers, share splits and rights issues.
3
Asset Managers - Global: Passive Market Share to Overtake Active in the US No Later than 2024, Moodys, February 2017.

ftserussell.com August 2017

Historically, the standard approach for passive investing has been to track a capitalization-weighted index in
which the indexs allocation to each constituent is determined by the constituents market value (its number of
4
shares outstanding multiplied by its share price).
In the context of indexing, smart beta is a generic term for indexes that depart from the standard market
capitalization weighting method in order to achieve particular objectives, such as the generation of excess
index returns, the mitigation of volatility, or diversification.
But despite their change in weighting approach, smart beta indexes share important characteristics with their
capitalization-weighted counterparts:

They share the principle of being constructed according to a consistent set of rules, rather than
relying on discretionary decisions.

They are transparent, so that any market participant can look up and familiarize themselves with the
details of the indexs construction.

A governance infrastructure also underlies any index, whether capitalization-weighted or smart beta. At FTSE
Russell, the index ground rules set out the management responsibilities of the entities involved in the
oversight of the index series: who acts as the benchmark administrator and the role of external advisory
committees including the FTSE Russell Policy Advisory Board. Separately, the FTSE Russell Governance
Board is responsible for ensuring that all the FTSE Russell indexes meet appropriate technical standards.
When choosing between standard, capitalization-weighted indexes and smart beta indexes as the basis of an
investment product, market participants often bear in mind questions of simplicity and transparency, cost,
liquidity, capacity and governance. The main attributes of the two types of index are set out in the table below:

Principal attributes of capitalization-weighted and smart beta indexes

Simplicity and Liquidity and

Type of index transparency
Capitalization- Simpleweighting
Weighted of each constituent
is proportional to
market
capitalization
Transparentindex
rules are disclosed
Smart Beta Variesfrom more
intuitive to more
complex
methodologies
Transparentindex
rules are disclosed
Cost capacity Governance
Low turnover- High liquidity and FTSE Russell
related trading capacity indexes have
costs transparent ground
rules and index
review process
Potentially higher Variesbut smart FTSE Russell
turnover-related beta index indexes have
trading costs than providers typically transparent ground
in capitalization- prioritize liquidity rules and index
weighted indexing and capacity in review process
index design

Source: FTSE Russell.

4
In practice, capitalization-weighted index constituents total shares outstanding are typically adjusted for investability or free float. This
means that any shares considered unavailable for trading, for example due to being held by owners, senior executives, governments,
pension schemes or other strategic shareholders, are deducted from the total.

FTSE Russell | The intuitive foundations of smart beta 2

Examples of smart beta index construction approaches
Although the complexity of design of smart beta indexes can vary, several indexes share the simplicity of
capitalization-weighting. One category of smart beta indexes includes those constructed according to intuitive,
common-sense (often called heuristic) rules. Among the most straightforward smart beta approaches are
equal-weighting and weighting by fundamental accounting measures.

Example 1: Equal weight

Equal weight indexes aim to increase diversification, alleviating the concentration concerns inherent in market
capitalization-weighted indexes.
In a capitalization-weighted index, constituents are weighted by the product of their share price and their
number of outstanding shares (i.e. by their market value). By contrast, in equal weight indexes constituents in
the underlying parent index receive an equal weight.
Due to stock market movements, the weights of individual constituents in equal weight indexes can become
unequal over time. For FTSE Russell indexes, eligible securities are reviewed annually and rebalanced to
equal weight on a quarterly basis.
As an approach, equal weighting helps address concerns about potential concentration risks in capitalization-
weighted indexes. For example, during the internet bubble of 1999-2000, stocks from the technology sector

gained particular prominence in capitalization-weighted indexes (see Figure 1, where the Russell 1000 Index
of US large-cap stocks is used as an example).
Such periods of concentration may have a significant effect on the index performance if the sector concerned
then suffers a period of relative underperformance.

Figure 1. Russell 1000 Index historical sector weights

100%
90%

80%
Weight in the index (%)

70%
60%

50%

40%
30%

20%
10%
0%
Jul-96

Jul-99

Jul-02

Jul-05

Jul-08

Jul-11

Jul-14
Apr-97

Oct-98

Apr-00

Oct-01

Apr-03

Oct-04

Apr-06

Oct-07

Apr-09

Oct-10

Apr-12

Oct-13

Apr-15

Oct-16
Jan-98

Jan-01

Jan-04

Jan-07

Jan-10

Jan-13

Jan-16

Consumer Discretionary Consumer Staples Energy

Financial Services Health Care Materials & Processing
Producer Durables Technology Utilities

Source: FTSE Russell, data as of February 28, 2017. Please see the end for important legal disclosures.

FTSE Russell | The intuitive foundations of smart beta 3

At the constituent level, the equal weight methodology can result in a significant underweight position of a few
large-cap stocks in comparison with the capitalization-weighted index.
For example, as can be seen in Figure 2, where the Russell 1000 Indexs Financial Services sector is used as
an illustration, the Financial Services sector stocks with the highest market value, such as JP Morgan,
Citigroup, US Banc Corp, American Express and BNY Mellon, receive a much smaller constituent weighting
(a relative underweight) in an equal-weighted index than in the Russell 1000 Index. These underweighted
stocks are shown at the left side of the chart.
At the same time, a long tail of small-cap stocks within the sector, visible on the right side of the chart,
receives a small weighting boost (and an overweight position relative to the capitalization-weighted index)
under the equal-weighted approach.

Figure 2. Weight differences in Russell 1000 Equal Weight Index, Financial Services sector

1% Limited overweight on many smaller cap stocks

Difference in stock weight: R1EW minus Russell 1000

0%

-1%

-2%

-3%

-4%

-5% Significant
underweight on
a few large cap
stocks
-6%

-7%
BB&T CORP

REGIONS FINANCIAL CORP

MID-AMER APT CMNTYS

PEOPLES UNITED FINANCIAL

FIRST HORIZON NATL CORP

EQUITY COMMONWEALTH

ASPEN INSURANCE HOLDINGS

PROASSURANCE CORP

ERIE INDEMNITY CO
JPMORGAN CHASE & CO
CITIGROUP INC

CITIZENS FINANCIAL INC

LINCOLN NATIONAL CORP

E TRADE FINANCIAL CORP

PUBLIC STORAGE INC

ANNALY CAPITAL MGMT INC

REINSURANCE GRP OF AMER

FIRST DATA CORPORATION

HOSPITALITY PPTYS TRUST

CHIMERA INVESTMENT CORP

EMPIRE STATE REALTY

CNA FINANCIAL CORP

AMERICAN EXPRESS CO
BANK OF NEW YORK MELLON

DISCOVER FINANCIAL SRVC

PROGRESSIVE CORP

EAST WEST BANCORP INC

WEX INC
ALLSTATE CORP

SEI INVESTMENTS CO

MARKETAXESS HOLDINGS INC

CARE CAPITAL PROPERTIES

FIDELITY NATL INFO SVCS

SL GREEN REALTY CORP

ALLEGHANY CORP

BROADRIDGE FINANCIAL INC

AMERICAN CAMPUS COMMUN

ZILLOW GROUP INC CLASS C

HEALTHCARE TR AMER INC

BANK OF HAWAII CORP
US BANCORP

LIBERTY PROPERTY TRUST

TCF FINANCIAL CORP

PAYPAL HOLDINGS INC

M & T BANK CORP

REALTY INCOME CORP

EQUIFAX INC
ALLIANCE DATA SYSTEMS
INVESCO LTD

RAYMOND JAMES FINANCIAL

SPIRIT RLTY CAP INC

WHITE MTNS INS GROUP LTD

BRANDYWINE REALTY TRUST

VANTIV INC

IRON MOUNTAIN INC

APARTMENT INVT & MGMT

HIGHWOODS PROPERTIES INC

ALLIED WRLD ASSUR COM

WESTERN ALLIANCE BANCORP

QUALITY CARE PROPERTIES

FIRST HAWAIIAN INC

Source: FTSE Russell, data as of December 31, 2016. Please see the end for important legal disclosures.

Given that an equal weight index overweights small-cap stocks by comparison with its capitalization-weighted
counterpart, index designers have to bear in mind the capacity and liquidity of the resulting index in order to
ensure its suitability for practical use as an underlying benchmark for index replicating financial products such
as ETFs.
Index designers can address potential liquidity and capacity concerns in an equal weight index by restricting
index eligibility to stocks with an adequate float-adjusted market value and to stocks whose average daily
trading volume (ADTV) is above a certain threshold.

FTSE Russell | The intuitive foundations of smart beta 4

Equal weighting is not a new index approach. In fact, one of the first commercially available index funds,
launched in the 1970s by Wells Fargo, was based on an equal weight index of shares on the New York Stock
Exchange (NYSE). The fund was wound up because it suffered from excessive transaction costsat the time,
5
transactions in US shares were subject to high minimum commissions.
In more recent times, dramatic reductions in share dealing costs have made equal-weighting a viable
proposition and the investment strategy is enjoying a resurgence of interest: roughly half of US financial
advisors recently surveyed by FTSE Russell said they either use or are very likely to use an equal-weighted
6
investment approach.

Example 2: Fundamental indexes

A second example of an intuitive smart beta index approach is fundamental indexation. Fundamental indexes,
like equal weight indexes, determine index constituents weights by some other measure than their stock
price. In general, fundamental indexes measure company size using fundamental measures such as sales,
operating cash flow, dividends and book value.
Research Affiliates (RAFI), which popularized the strategy from 2005, notes that fundamental indexation also
follows a contrarian rebalancing approach, systematically trading out of constituents whose prices have
7
increased and increasing the allocation to securities whose prices have decreased.

Applying the fundamental index approach

The Russell RAFI Index Series ranks and weights companies by averaging three fundamental factors:

1. Adjusted salesconstituent sales are averaged over five years and then adjusted to take into
account financial leverage, decreasing the index weight of companies with significant leverage

2. Retained operating cash flowthe five-year average cash flow from operations, less dividends
and buybacks

3. Dividends and buybacksthe five-year average of dividends paid and share buybacks
Empirical evidence shows that fundamental measures of companies size are relatively highly correlated with
the companies market capitalizationin other words, a stock that scores highly on fundamental measures
8
tends also to have a high market value. In practical terms, this means that capacity and liquidity constraints
in fundamental indexes may be less of a concern than for other types of smart beta indexes.

Smart beta performance in context

Investors selecting smart beta indexes typically do so for a variety of reasons, such as the generation of
excess index returns, the mitigation of volatility or diversification. The resulting performance of smart beta
must therefore be seen in the context of the original objectives.
At a headline level, the total return of both a fundamental and an equal weight version of the Russell 1000
Index exceeded that of the capitalization-weighted reference index over the period from December 1999 to
May 2017 (see Figure 3). However, over the most recent 1-, 3-, 5- and 7-year periods, the capitalization-
weighted Russell 1000 Index provided a slightly higher per annum total return (see Figure 4).

5
See The High Cost of Equal Weighting, Research Affiliates, May 2014.
6
Source: FTSE Russell, Smart beta: 2015 survey findings from US financial advisors. The survey included advisors with AUM greater
than $20 million, at least 4% of AUM invested in ETFs and at least 20% fee-based annual revenue.
7
See https://www.researchaffiliates.com/en_us/strategies/rafi/rafi-fundamental-index.html.
8
In their 2005 paper, Fundamental Indexation, Arnott, Hsu and Moore showed that the weighted average capitalization of a
fundamental index is around two-thirds as large as that of the reference capitalization-weighted index, but the concentration ratio of the
fundamental index (the proportion of the overall index represented by the collective weightings of largest 100 stocks) is similar to that of
the capitalization-weighted index.

FTSE Russell | The intuitive foundations of smart beta 5

Figure 3. Total return of Russell 1000, Russell 1000 Equal Weight and Russell RAFI US Indexes

600

500

400

300

200

100

Russell RAFI US Russell 1000 Equal Weight Russell 1000

Source: FTSE Russell, data from December 31, 1999 to May 31, 2017. Index levels are rebased to 100 on December 31, 1999. Past
performance is no guarantee of future results. Returns shown may reflect hypothetical historical performance. Please see the end for
important legal disclosures.

Figure 4. Annualized total returns of Russell 1000, Russell 1000 Equal Weight and Russell RAFI US
Indexes

1 year 3 years 5 years 7 years 10 years 15 years

Russell RAFI US 14.82% 8.14% 15.14% 14.00% 7.81% 9.46%
Russell 1000 Equal Weight 14.06% 7.28% 14.78% 13.97% 8.69% 11.26%
Russell 1000 17.49% 9.83% 15.37% 14.37% 7.01% 8.02%

Source: FTSE Russell, data as of May 31, 2017. Past performance is no guarantee of future results. Returns shown may reflect
hypothetical historical performance. Please see the end for important legal disclosures.

The divergence in performance from the capitalization-weighted Russell 1000 Index is paralleled by a
divergence in the smart beta indexes risk statistics from those of the reference index (see Figure 5). Both in
terms of standard deviation of return and in terms of tracking error, the Russell 1000 Equal Weight Index
showed a greater divergence from the reference Russell 1000 Index than the Russell RAFI US Index.

FTSE Russell | The intuitive foundations of smart beta 6

Figure 5. Index risk statistics

Standard Deviation 3 years 5 years 10 years

Russell RAFI US 10.3% 9.9% 16.4%
Russell 1000 Equal Weight 11.6% 10.6% 18.1%
Russell 1000 10.3% 9.6% 15.4%
Tracking Error 3 years 5 years 10 years
Russell RAFI US 2.6% 2.4% 3.0%
Russell 1000 Equal Weight 3.9% 3.5% 5.2%
Russell 1000 0.0% 0.0% 0.0%

Source: FTSE Russell, data as of May 31, 2017. Past performance is no guarantee of future results. Returns shown may reflect
hypothetical historical performance. Please see the end for important legal disclosures.

The deviation of the smart beta indexes return and risk measures from those of the reference index should
be considered in terms of the stated objectives of the two different smart beta approaches.
For the Russell RAFI US Index, whose objective is to select securities based on fundamental measures,
rather than stock price, the concentration level in the top ten securities is similar to that of the capitalization-

weighted reference indexin this case, the Russell 3000 Index (see Figure 6).
At the same date, the Russell RAFI US Index also exhibited an improvement in fundamental scores vis--vis
9
its capitalization-weighted counterpart, the Russell 1000 Index (see Figure 7). Although it had a higher price-
earnings ratio, the Russell RAFI US Index had lower price-to-sales and price-to-book ratios than the reference
index, as well as a higher dividend yield.
For the Russell 1000 Equal Weight Index, the effective number of securities (Effective N) in Figure 6 is
markedly higher than that of the reference index, the Russell 1000, while the concentration in the top ten
10
holdings is markedly lower than that of the reference index. These statistics, together with the relatively high
active share, show that the index is meeting its primary objectives of reducing concentration and increasing
diversification.

Figure 6. Active share and concentration measures for the Russell 1000 Equal Weight and Russell
RAFI US Indexes

Russell 1000
Index-level statistics Russell RAFI US Equal Weight Russell 1000 Russell 3000
Active share 0.24 0.53 n/a n/a
Effective N 159 766 162.5 189.3
Number of securities 1485 982 1000 3000
Weight in top 10 17.8% 2.4% 15.9% 17.2%

Source: FTSE Russell, data as of May 31, 2017. Active share for the Russell RAFI US Index is measured relative to the Russell 3000
Index and Active Share for the Russell 1000 Equal Weight Index is measured relative to the Russell 1000 Index. Please see the end for
important legal disclosures.

9
The Russell 1000 Index of large-cap stocks is used here for purposes of comparison (the Russell RAFI US Index draws from a starting
universe of the Russell 3000 Index).
10
The Russell 1000 Equal Weight Index uses a modified version of the equal weight methodology, in which sector weights are first
equalized, then constituent weights are equalized within each Sector. A pure, constituent-level equal weight index would have an
Effective N equal to the number of constituents in the starting universe (in this case, 1000).

FTSE Russell | The intuitive foundations of smart beta 7

Figure 7. Valuation measures for the Russell RAFI US Index

Price to sales Price to book Price earnings Dividend yield

Index ratio ratio ratio (%)
Russell RAFI US 1.23 2.44 27.45 2.37
Russell 1000 2.04 3.10 23.95 1.97

Source: FTSE Russell, data as of May 31, 2017. Please see the end for important legal disclosures.

Conclusion
Smart beta doesnt have to be complex. While some non-traditional index approaches rely on more involved
quantitative modelling, some popular smart beta index construction approaches follow simple, intuitive
methodologies. Equal-weighted and fundamental indexes are two such approaches: they use a
straightforward construction methodology in order to address potential concentration or valuation concerns
inherent in capitalization-weighted indexes.
When choosing between standard, capitalization-weighted indexes and smart beta indexes, market
participants often bear in mind questions of simplicity and transparency, cost, liquidity, capacity and
governance. Index users should also evaluate smart beta in the context of the original objectives, such as the
generation of excess index returns, the mitigation of volatility, or diversification. This information is as readily
available as it is for capitalization-weighted indexes and should not be an obstacle to considering smart beta
alongside more traditional index options.

FTSE Russell | The intuitive foundations of smart beta 8

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FTSE Russell 9
About FTSE Russell
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