Beyond the benchmark: unpacking smart beta strategies

Passive investing is a strategy that seeks to replicate the performance of a specific market index whilst minimising costs and turnover. It’s based on the principle that financial markets are broadly efficient over the long term, making it both difficult and expensive to consistently beat the market through active management.

For advisers, passive funds offer a cost-effective way to gain diversified market exposure, particularly in well-researched, liquid markets. Their simplicity, transparency, and low fees make them a valuable tool in portfolio construction.

While traditional index tracking funds aim to replicate indices without discretion, the investment universe now includes other forms of passive or semi-passive strategies, such as smart beta strategies: a hybrid approach that blends passive and active investing. These strategies don’t simply track market capitalisation indices but apply systematic tilts toward factors such as value, momentum, or low volatility, aiming to enhance returns or manage risk.

Smart beta funds maintain a rules-based framework but introduce active decision-making through factor selection and index construction. They can be particularly useful for advisers seeking to tailor portfolios to specific client objectives without the higher costs of full active management.

In this article, we will explore the advantages and limitations of traditional passive investing, and outline different smart beta strategies.

Lower fees: Traditional passive funds typically have lower fees than active funds, as they don’t require extensive research or active stock selection. Smart beta funds may carry slightly higher fees due to their strategic overlays but remain more affordable than active strategies.

Transparency: Passive funds disclose their holdings clearly, as they aim to replicate the returns of an index. This contrasts with active funds, which may only reveal top holdings, limiting visibility for clients.

Exposure: Passive funds provide quick and broad market exposure, which is useful for asset allocators. They enable access to broad country or regional exposure without much risk of significant underperformance against the market and does not discriminate against certain sectors or countries like an active fund does.

Performance: Passive investing works especially well in large, liquid markets. These markets are heavily researched, making it harder for active managers to find undervalued opportunities. According to research by Morningstar, only 21% of active strategies in the US outperformed their passive counterparts over the 10 years through to June 2025¹.

Smart beta strategies can be particularly useful for advisers seeking to tailor portfolios to specific client objectives without the higher costs of full active management.

No Outperformance: Passive funds are designed to match the market return, not beat it. They rise and fall with the index and cannot avoid poorly performing or overvalued stocks.

Bond market challenges: Passive corporate bond funds face issues such as index bias, whereby market cap-weighted indices often favour the most indebted issuers; investability, in that not all bonds in an index may be practical to buy, leading to tracking differences; and frequent rebalancing, which can increase transaction costs.

Concentration risk: Some indices are heavily weighted towards specific sectors. This is certainly the case in many global and US indices currently, which have large exposure to tech stocks. This can lead to volatility if these sectors underperform.

Rebalancing costs: Passive funds must rebalance to stay aligned with the index, which can be costly in volatile or illiquid markets.

A value-focused smart beta strategy focuses on undervalued stocks in the index based on financial metrics such as price-to-earnings or price-to-book ratios, targeting potential gains as prices correct. This strategy can be useful for clients seeking long-term growth and downside protection.

A quality-focused smart beta strategy focuses on companies with strong fundamentals, such as stable earnings, low debt, and high return on equity. By prioritising financially sound businesses, this approach seeks to deliver more consistent performance, particularly during periods of market volatility. This strategy can be suitable for more risk-averse clients.

A momentum-focused smart beta strategy seeks to capitalise on the tendency of stocks that have performed well in the recent past to continue performing well in the near future, typically by focusing on companies showing strong upward price trends or positive earnings revisions. This approach can help boost returns by riding market winners, especially during bullish phases. While momentum strategies can be more volatile, they can offer clients the potential for enhanced performance. They are often used to complement other factors like value or quality.

A size-focused smart beta strategy targets companies based on their market capitalisation, often tilting towards smaller-cap stocks. This type of strategy can enhance portfolio diversification and provide exposure to growth opportunities that may be overlooked in traditional market-cap-weighted indices, which in today’s market environment are dominated by large tech names.

There are many more types of smart beta strategies too. For example, risk-orientated funds that focus on companies with low historical volatility, or equal-weight funds that assign an equal weight to each holding in the index, to reduce concentration risk.

¹Morningstar’s US Active/Passive Barometer, Midyear 2025