What exactly is 'smart beta' or factor investing, and how does it differ from traditional passive indexing?

Factor investing (often marketed as 'smart beta') sits at the intersection of active and passive management. It uses systematic, rules-based approaches to capture specific return drivers — without the discretionary stock-picking of traditional active management.

Traditional Indexing vs. Factor Investing:

Feature	Cap-Weighted Index	Factor/Smart Beta
Weighting	Market capitalization	Factor exposure (value, momentum, etc.)
Rebalancing rule	Float-adjusted cap	Systematic factor screens
Active decisions	None	Factor selection, rebalancing frequency
Fees	Very low (3-10 bps)	Low-to-moderate (15-50 bps)
Concentration risk	Tilted to mega-caps	Depends on factor

The Major Factors (Fama-French + Extensions):

1. Value — Buy stocks with low P/B, P/E, or high dividend yield. Based on the observation that 'cheap' stocks tend to outperform over long horizons.
2. Size (Small-Cap) — Smaller companies have historically delivered higher returns than large-caps, possibly as compensation for liquidity and information risk.
3. Momentum — Stocks that have performed well over the past 6-12 months tend to continue outperforming in the near term.
4. Quality — Companies with high profitability, low leverage, and stable earnings tend to outperform, especially in downturns.
5. Low Volatility — Contrary to CAPM predictions, low-volatility stocks have delivered similar or higher risk-adjusted returns than high-volatility stocks.

Example: Cedric Asset Management launches a 'multi-factor' ETF that screens the Russell 1000 for stocks in the top 30% by momentum, top 30% by quality, and bottom 30% by valuation. It equal-weights the ~120 stocks that pass all three screens and rebalances quarterly. This is systematic (passive-like) but non-cap-weighted (active-like).

Is It Active or Passive? The CFA curriculum treats factor investing as a middle ground. It's rules-based like passive but makes active bets on which factors will deliver premiums. The key risk is that any factor can underperform for extended periods — value, for instance, lagged growth for most of the 2010s.

Explore more equity strategies in our CFA Level I practice questions.