THE JOURNAL OF

SUMMER 2015 VOLUME 6 NUMBER 1 | www.IIJII.com ETFs, ETPs & Indexing

The Voices of Influence | iijournals.com

Smart Beta Strategies as

Outcome-Oriented Solutions
in the Equity Space
URSULA MARCHIONI, SOFIA ANTROPOVA,
AND CATHERINE MCNAUGHT

URSULA M ARCHIONI
is a director and head of
iShares EMEA Equity
Strategy & ETP Research
at BlackRock in London,
U.K.
ursula.marchioni@blackrock.com
SOFIA A NTROPOVA
is a director and invest-
ment strategist at Black-
Rock in London, U.K.
sofia.antropova@blackrock.com
CATHERINE
MCNAUGHT
is vice president and
investment strategist at
BlackRock in London,
U.K.
catherine.mcnaught@blackrock.
com
SUMMER 2015
Smart Beta Strategies as
Outcome-Oriented Solutions
in the Equity Space
URSULA MARCHIONI, SOFIA ANTROPOVA,
AND CATHERINE MCNAUGHT
T
he growth of index investing
has been one of the key trends
in financial markets over recent
decades. Since the launch of the
first index fund in the early 1970s, indexing
has expanded to account globally for over
5.3 trillion USD1 of assets under manage-
ment (AUM) in retail funds and exchange-
traded funds (ETFs) alone. In the U.S., index
mutual funds and exchange-traded products
(ETPs)of which ETFs are the largest cate-
goryboast a total of almost 4 trillion USD
in AUM, or 28% of the retail asset manage-
ment industry. In Europe, this category of
assets has almost tripled over the last 10 years,
rising from 4.5% of total AUM in 2004 to
12.6% in 2014, or 952 billion USD.2
This stellar growth in index investing
can be linked to several drivers. The first
driver is the breadth of benefits delivered by
these strategies to investors. Index investing
may reduce portfolio risk through diversifi-
cation, as indices are made up of a broad set
of individual securities; turnover and trans-
action costs can be controlled by embedding
dedicated pre-defined rules within the index;
index strategies can be efficiently included
within portfolio risk-management frame-
works, as their risk and return drivers are
comparatively easy to model and monitor.
A second driver behind the growth
in index investing is the breadth of appli-
cations for indices. Indices are nowadays
broadly used as a gauge for market sentiment,
allowing for a measure of a specific market
or segment behavior; they can be used as a
tool for performance measurementhelping
investors to measure the average risk/
return achieved by a market, and to assess
the outperformance of an active strategy.
Furthermore, by representing key drivers
of investment returnsthrough style, size,
sector, and country indicesindices can
help investors achieve a more focused asset
allocation strategy, as portfolio performance
can be properly attributed to the different
underlying return drivers.
A third driverand the main focus
of this articlelies in the ever-increasing
range of available index strategies and in
the capacity these solutions have to evolve
and adapt to varying market conditions and
investor needs. From the creation of the first
index, a price-weighted instrument to mea-
sure the performance of the U.S. railway
sector introduced by Dow and Jones in 1884,3
we can now identify more than one million
indices available today in the equity space.4
As this number indicates, the concept of
index investing is continuously expanding,
as the evolution of financial markets and that
of providers research allows for new applica-
tions for investors.
Traditional beta is often identified with a
market capitalization-weighted approach to
equity investing; which has its foundations
THE JOURNAL OF INDEX INVESTING
in the capital asset pricing model (CAPM) and whereby
index constituent weights are calculated as the product
of freely traded shares times their current market price.
While arguably the majority of the assets invested in
index strategies remain in this type of beta portfolios,
we are witnessing an ever-growing interest in new
ways of indexing that go beyond market-capitalization-
weighted solutions. These strategies are often collec-
tively referred as smart beta. While differing greatly
across many aspects, these strategies share the aim of
identifying, describing, and providing exposure to dif-
ferent sources of returns beyond those provided by tra-
ditional market-capitalization-weighted indices.
One of the most fascinating aspects of this expan-
sion of the definition of beta lies in the fact that smart
beta strategies offer a passive access to risk and return
drivers which have historically been associated with
active investing alone. The notion of a continuum of
beta, which ranges from traditional beta to pure alpha
(with smart beta strategies falling in between) is increas-
ingly replacing the idea of a barbell approach to alpha
and beta.
In the following sections, we focus on traditional
beta and on the middle ground of this beta continuum,
by providing a sample review of market-capitalization-
weighted and smart beta strategies in the equity space.
We look at their respective growth, specifically in the
ETP space, and at their risk/return characteristics, to
understand if there is any merit in implying that certain
solutions are more clever than others, and can therefore
deliver consistent outperformance.
A BRIEF HISTORY OF THE EXPANSION OF
THE BETA CONTINUUM IN EQUITY SPACE
The idea of combining stocks to accurately rep-
resent the risk and return drivers of a given market or
exposure based on weights other than the market capi-
talization of the companies themselves is very old; the
first index ever created was not actually a market-cap-
italization-weighted one. Nevertheless, today market-
capitalization indices still represent the lions share of
index investing: the near totality of indices used as a
market gauge is represented by market-capitalization
indices5 and the majority of the assets invested in index
strategies is linked to market-capitalization-weighted
benchmarks.
SMART BETA STRATEGIES AS OUTCOME-ORIENTED SOLUTIONS IN THE EQUITY SPACE
This status quo was initially driven by the benefits
of market-capitalization-weighted strategies.6 In addi-
tion, as market capitalization strategies became more
popular, more products appeared in this space, more
investors bought into them, and more portfolios were
built with a risk framework tailored to this specific type
of beta. This ultimately led several investors to identify
beta with market-capitalization-weighted indices. For
the broad investing public, many alternative beta strat-
egies were generally neglected, despite being heavily
used by a more restricted group of highly sophisticated
investors, or indeed by active managers.
During the last 10 years, however, this situation
has evolved as we have witnessed a significant interest
by the press and by the broader investment community
in non-cap-weighted forms of index investingalso
known as smart beta strategies. A good proxy to measure
the growth in the category can be found in the history
and evolution of the ETP industrywhich is relatively
easy to measure and report on.
The first two so-called smart beta ETFs were
launched in the U.S. in 2005;7 since then, we have
witnessed a strong wave of issuance of U.S. domiciled
smart beta ETFs, which now dominate the offering
within the global smart beta ETF universe. The first
three European-domiciled smart beta ETFs were also
launched in 2005, offering exposure to dividend focused
local-exposure benchmarks; these ETFs have been very
successful, having now reached a total of over 1.7 bil-
lion USD in AUM8 and several solutions are available
in Undertakings for Collective Investments in Trans-
ferable Securities (UCITS) format across fundamen-
tally weighted, single-factor, multi-factor, and equally
weighted strategies. Globally, AUM allocated to smart
beta ETPs have steadily increased over the last five years,
from accounting for 6% of the total equity ETP AUM
in 2009 to accounting for 11% now.9 As measured by
the cumulative annualized growth rate (CAGR),10 tra-
ditional beta ETP AUM have grown at a rate of 14%,
while smart beta ETPs have had a substantially stronger
growth rate of 37%.
Looking more closely at the popularity of different
strategies, dividend-weighted ETFs11 currently represent
the largest portion of the equity smart ETP space in
terms of AUM, both globally and in Europe: Four out
of five of the largest smart beta global ETFs provide
exposure to high dividend stocks, accounting for over
SUMMER 2015
60 billion USD in AUM;12 in Europe, we observe an
identical picture, with ETFs tracking dividend strategies
and accounting to over 5.5 billion USD13 in AUM.
Minimum-volatility, equally weighted, and multi-
factor exposures are the next most popular smart beta
solutions delivered in ETP format. Specifically, after
the launch of the first minimum-volatility ETF in 2011,
these trackers now account for over 12% of the smart
beta equity ETP AUM, globally.14
Historical ETP f lows illustrate the continued
growth over the last five years. The trend continues in
2015, with YTD ETP f lows into global smart beta ETPs
contributing to 28% of the total equity ETP f lows so
farwhile only representing 11% of the total assets.15
Based on this growth, a series of questions is cur-
rently under discussion among investors, academics, and
market practitioners. Are smart beta solutions superior to
traditional beta, as the adjective smart implies? Should
investors consider substituting a significant portion

EXHIBIT 1
Global Equity ETPs AUM: Traditional and Smart Beta

Source: BlackRock ETP Landscape. As of the end of Mar-2015. AUM for the two categories are measured in USD. Figures in brackets represent the
compounded annual growth rate (CAGR) of the assets since the end of 2009.

EXHIBIT 2
Global Equity ETP Flows: Traditional and Smart Beta
ETPs have seen continued growth over the last 5 years, with global smart beta f lows growing faster in 2015 YTD.

Source: BlackRock ETP Landscape. As of the end of Mar-2015. Flows for the two categories are measured in USD.

SUMMER 2015 THE JOURNAL OF INDEX INVESTING

of their allocation to traditional beta with smart beta
solutions?
While there is no doubt that smart beta solutions
will continue to grow, we believe that the key to their
success within portfolios lies in an outcome-oriented
approach, which we outline in the next two sections.
TRADITIONAL AND SMART BETA
IN THE EQUITY SPACE: BENEFITS
AND CONSTRAINTS
Non-cap-weighted index strategies deviate from
traditional beta by definition. Regardless of the meth-
odology, any alternatively weighted index will include
explicit or implicit biases towards specific risk factors or
themes. These exposuresintended or otherwisewill
drive any outperformance or underperformance relative
to a standard index. Understanding the nature and per-
sistence of these biases is therefore a critical component
of smart beta investing. In this section, we will review a
sample of equity beta strategieshighlighting their fun-
damental characteristics (benefits and limitations) and
examining different scenarios that may lead to superior
or inferior performance.
Traditional, or Market-Capitalization-
Weighted, Beta Strategies
Traditional market-cap-weighted index strategies
are based on a set of rules whereby security weights are
calculated on the basis of a number of its freely traded
shares and the current market price. A cap-weighted
index is weighted by company size; larger stocks have a
higher weight than do smaller stocks.
There are multiple benef its offered by cap-
weighted index strategies. These indices are essentially
self-rebalancing: when the price of a stock moves, so
does its market capitalization, resulting in low turnover
and transaction costs. Furthermore, because larger com-
panies are more heavily weighted by definition, these
strategies tend to be highly liquid and generally easily
replicable in real-world portfolios. Finally, by defini-
tion, these strategies are a very effective means for inves-
tors to participate in rallying markets. This last benefit
nevertheless also coincides with the main limitation of
market-capitalization-weighted strategies as they can be
more exposed to price bubbles.
SMART BETA STRATEGIES AS OUTCOME-ORIENTED SOLUTIONS IN THE EQUITY SPACE
In Exhibits 3 and 4, we look at a well-known
market-capitalization-weighted index: the S&P 500
total return gross index (SP500)during the dot-com
bubble of the early 2000s. We compare this index with
perhaps the most straightforward smart beta strategy, the
S&P 500 equally weighted total return gross index (S&P
500 EW).16
Technology companies rallied significantly from
late 1996 to Dec-1999, many of which were notoriously
overvalued by the end of the 1990s. During this period,
the S&P 500 outperformed the S&P 500 EW index
by over 10% p.a.hence representing a smart choice
for investors during the period. The same choice over
the period from Mar-2000 to Sep-2002 nevertheless
led to a very different result: when the dot-com bubble
burst, its heavy overweight in highly priced technology
stocks led to a significant underperformance versus the
more diversified S&P 500 EW. This example illustrates
the very different performance experience that may
result from simple index construction choices. We fur-
ther touch upon the benefits and limitations of equal-
weighted strategies below.
A similar situation was observed during the finan-
cial crisis of 20072008, when investors with large allo-
cations to market-capitalization-weighted indices were
hit the hardest, due in large part to the indices high
concentration in financial names. The massive draw-
down in equities experienced during the financial crisis
was arguably one of the key drivers in the development
and adoption of smart beta strategies, as it led investors
to seek alternative ways to build index strategiesfor
example minimum-volatility strategiesto seek better
diversification, the potential for incremental returns and
reduced risk.
Smart Beta: Minimum-Volatility Strategies
In minimum-volatility strategies,17 the weights of
the index constituents are linked to the stocks realized
historical volatility levelswith the least volatile names
being overweighted with respect to the more volatile
ones through different mechanisms.18 As a result, the
least volatile stocks are overweighted compared with
their weight in the equivalent market-capitalization-
weighted indices.19
Minimum-volatility strategies seek to provide
equity market participation with less volatility com-
SUMMER 2015
EXHIBITS 3 AND 4
Comparative Behavior of the S&P 500 and the S&P 500 Equally Weighted Gross Total Return Indices, Before
and After the Dot-Com Bubble

Notes: As implied by its name, this latter index invests in the same 500 companies included in the traditional index, however each of them has the same
weight in the benchmark index.
Source: Bloomberg, BlackRock. Based on USD denominated gross total return indices. Index values in the bottom charts have been re-based to 100 as of
31-Dec-1999 and 31-Mar-2000, respectively, in order to measure and compare index performances. Past performance is not an indicator of future results.

pared to the standard (market-capitalization-weighted) rounding expected performance. Minimum volatility

index. This feature has generated investor interest in
a variety of minimum-volatility strategies, ranging
from U.S., developed, and emerging markets equities.
Over the long run, minimum-volatility strategies have
lower losses during market downturns while providing
a disproportional amount of upside participation. The
marked asymmetry of minimum-volatility portfolios, as
illustrated in Exhibit 6, may be explained by a combina-
tion of behavioral and structural anomalies that result
in the mispricing of low-risk securities relative to their
higher risk peers.20
Minimum-volatility strategies are also useful
whenever investors have a desire to maintain exposure
to a given market but with softening conviction sur-
strategies can be a very effective tool to capture part of
the upside of a market while limiting losses in downturn
scenarios (Exhibit 6). Despite their strong long-term
performance, low-volatility strategies will tend to lag
market-capitalization-weighted indices in rallying mar-
kets, as shown in Exhibit 7.
Smart Beta: Fundamental and Equally
Weighted Strategies
Many of the first forms of smart beta equity strate-
gies were based on simple, heuristic rules for portfolio
construction. Two of the most widely adopted forms
of equity smart beta are fundamentally weighted and

SUMMER 2015 THE JOURNAL OF INDEX INVESTING

EXHIBIT 5
Comparative Behavior of the S&P 500 Total Return Net Index and the S&P 500 Minimum Volatility Total Return
Net Index During the Financial Crisis
While allocation to the S&P 500 Minimum Volatility Strategy would not have fully removed the underperformance, it would have helped
to absorb some of the impact.

Source: Bloomberg, BlackRock. Based on USD denominated net total return indices. Index values have been re-based to 100 as of 31-Oct-2007. Past
performance is not an indicator of future results.

equally weighted strategies. The weights of index con- Turnover can also be significantly higher than that of
stituents within fundamental strategies are based on fun- the respective traditional index, further increasing the
damental indicators such as a companys sales, cash f low, importance of thoughtful implementation that mind-
or book value. Security weights in equally weighted fully trades return, risk, and cost.
strategies, as the name implies, is determined
by 1/n, with each security receiving the
same weight. Both methodologies result in E X H I B I T 6
a bias towards smaller, more value-oriented Asymmetrical Performance of Minimum Volatility Strategies
securities. These factor biases help explain
the majority of the strategies relative per-
formance, as both value and size have been
demonstrated to earn a return premium
over the long term.21 Exhibit 8 compares
the performance of the MSCI World Value
Weighted Index (a fundamentally weighted
strategy) compared to the standard MSCI
World Index, illustrating the impact of these
implicit style biases on index performance.
While the biases towards value-
oriented and smaller companies may result
in strong long-term performance, they also
increase the complexity of implementation.
Smaller names are generally less liquid, Source: Morningstar. Based on monthly index returns from 1-Dec-20091-Dec-2014. Past per-
with higher potential transactions costs. formance is not an indicator of future results. MSCI USA MV Index was launched on 30-May-
2008, all other MSCI MV Indices above incepted on 30-Nov-2009.

SMART BETA STRATEGIES AS OUTCOME-ORIENTED SOLUTIONS IN THE EQUITY SPACE SUMMER 2015
EXHIBIT 7
Rallying Markets Present Challenges for Minimum Volatility Strategies

Source: Bloomberg,BlackRock. For the period 9-Mar-200915-Apr-2010. Based on USD denominated net total return indices. Index values have been
re-based to 100 as of 9-Mar-2009. Past performance is not an indicator of future results.

EXHIBIT 8
Comparative Behavior of the MSCI World and the MSCI World Enhanced Value Indices

Source: MSCI, Bloomberg, BlackRock. Based on USD denominated Net total return indices as of the end of Mar-2015. Index values have been re-based
to 100 as of 1-Jan-2011. Past performance is not an indicator of future results.

SUMMER 2015 THE JOURNAL OF INDEX INVESTING

FACTOR STRATEGIES: A POWERFUL differences in performance. For example, traditional
SET OF SMART BETA SOLUTIONS (cap-weighted) value indices, fundamentally weighted
indices and value-factor indices all provide investors
As we have noted, any non-cap-weighted strategy with a tilt towards value-oriented securitiesbut with
will include implicit style biases that result from portfolio a very different total performance experience.
construction rules. The recognition of these implicit In particular, security selection (screening) and
biases has given rise to a new category of smart beta security weighting decisions have the largest impact on
strategies that are explicitly constructed to isolate and portfolio characteristics and performance. Some smart
capture one or more style factors. Factor-based strategies beta indices re-weight all securities in a particular uni-
are now one of the largest and fastest growing categories verse; others include only a subset of securities that
of smart beta ETPs: Of the total 248 billion USD in are ranked highest along particular factor dimensions.
smart beta ETPs (from Exhibit 1) Factor categories Unlike traditional style indices, which cap-weighted a
like Reduced Volatility,22 Single-Factor Exposures, subset of value-oriented securities for example, smart
and Multi-Factor Exposures contribute c. 88 billion beta indices are generally not cap-weighted.
USD (Exhibit 9). While these differences might appear subtle, the
Factor strategies seek to identify common charac- index rules governing stock selection and weighting
teristics driving risk and returns in equity markets. Cer- criteria have a profound impact both on the perfor-
tain factors have historically delivered a positive return mance of these benchmarks and on their exposure to
over the long term, compensating investors for bearing the underlying markets factors. Exhibit 12 shows, as an
risk or capturing long-standing market anomalies. These example, a comparison in the historical performances
factors are nothing more than the intuitive invest- of the MSCI World, MSCI World Value (a style index),
ment ideas that have driven stock selection for decades: MSCI World Value-Weighted (a fundamental index),
Value ref lects the notion of buying low and selling high; and MSCI World Enhanced Value (a factor index) net
Quality ref lects the idea of overweighting strong com- total return indices.23
panies and underweighting weak companies. Exhibit 10 It should be noted that the majority of index-
illustrates the long-term incremental return delivered by based factor strategies available are long-only strategies.
two well-understand risk factors: volatility and quality.
Specifically, over the longer term, low-
volatility and high-quality stocks have
outperformed high-volatility and low- E X H I B I T 9
quality stocks respectively, as shown in Global Equity Smart Beta ETFs AssetsFactor ETPs is the Second
Exhibit 10. Largest Growing Category
The innovation of smart beta strat-
egiesand factor strategies in particular
is not the discovery of these factors, but
rather the ability capture them in a low-
cost and transparent form. In essence,
smart beta strategies aim to rewrite
investment rules to create deliberate,
diversified outcomes based upon this
factor-based view of the world.
One potential challenge for inves-
tors, though, is linked to the selection
of the most appropriate index to match
an investors portfolio needs and goals.
Many index strategies may sound alike,
but subtle differences in portfolio con- Source: BlackRock ETP Landscape. As of the end of Mar-2015.
struction choices may lead to large

SMART BETA STRATEGIES AS OUTCOME-ORIENTED SOLUTIONS IN THE EQUITY SPACE SUMMER 2015
EXHIBIT 10
Cumulative Active Returns for Minimum Volatility and Quality Indices
Source: Bloomberg, BlackRock. As of the end of March 2015. Based on USD denominated net total return indices. Risk premiums measured as the rela-
tive performance of the World Minimum Volatility and the World Quality indices with respect to the parent MSCI World Index. Minimum Volatility:
MSCI World Minimum Volatility Index (M00IWO$O Index), Quality: MSCI World Sector Neutral Quality Index (M1WONQ Index). Past per-
formance is not an indicator of future results.
EXHIBIT 11
Comparing Portfolio Construction Rules
An investors key challenge is the selection of the most appropriate
index to match their portfolio needs and goals.
Source: BlackRock, for illustrative purposes only.
A large proportion of portfolio risk is therefore related
to the underlying market exposure and its inherent
macroeconomic risk. While long-only factor strate-
gies can provide a tilt towards the desired factor, a
SUMMER 2015
long/short implementation would be required to pro-
vide pure exposure to a desired factor. The shorting
required makes such strategies more challenging in an
ETF format, but still worthwhile investment proposi-
tions for those investors seeking to isolate factor expo-
sures from market exposures.
PUTTING SMART BETA TO WORK
The proliferation of smart beta strategies can make
it challenging to understand the potential role smart
beta can play in investor portfolios. Some strategies are
focused on delivering exposure to a single smart beta
factor, and others provide exposure to several factors
(intended or otherwise!). Some forms of smart beta
are not explicitly anchored to factor investing, instead
focusing on using the smart beta toolkit to seek specific
outcomes or more efficient versions of exposure to a
particular asset class.
At the risk of oversimplifying, we divide the world
of smart beta into two types of strategies: precision tools
and solutions. Some investors are more tactical by nature
and prefer to build custom portfolios for themselves.
Single-factor funds, for example, provide a toolkit to
THE JOURNAL OF INDEX INVESTING
EXHIBIT 12
Historical Performance of MSCI World Value (Style), MSCI World Value-Weighted (Fundamental), and MSCI
World Enhanced Value (Factor) Indices Compared to MSCI World

Source: MSCI, Bloomberg, BlackRock. As of the end of Mar-2015. Based on USD denominated net total return indices.
Index values have been re-based to 100 as at 1-Jan-2001. Past performance is not an indicator of future results.

EXHIBIT 13
Factor Investing Across Business Cycles

Source: BlackRock. The chart above is an indicative illustration by the authors of various phases of macro-economic/business cycles and the factors that
could potentially produce better returns in each stage.

express an investment view. Other investors are more Multi-factor strategies, for example, are designed to be
interested in well-diversified strategies that have been a part of investors long-term core holdings.
devised by an asset manager or index provider that seeks For more tactically minded investors, the distinct
to perform well in a variety of market environments. cyclicality of style factors, along with their historically

SMART BETA STRATEGIES AS OUTCOME-ORIENTED SOLUTIONS IN THE EQUITY SPACE SUMMER 2015
low correlations with each other, can make single factor
strategies a useful tool to implement investment views
or hedge risks along factor dimensions. Certain factors
tend to be naturally pro-cyclical (such as Value, Size
and Momentum) and others counter-cyclical (such as
Quality and Minimum Volatility. Indeed, factors have
been highly cyclical historically, with sensitivity to var-
ious stages of the economic cycle. Just as many investors
make tactical adjustments to country or sector alloca-
tions, factor strategies provide another tool to express
a market view.
Many investors seek bespoke combinations of fac-
tors to ref lect their market views and goals for risk and
return. For example, Exhibit 14 compares the historical
performance of two bespoke factor portfolios, compared
to the standard MSCI World Index. The defensive
factor portfolio includes quality and minimum volatility,
while the aggressive factor portfolio includes expo-
sures to momentum, size, and value.24 Not surprisingly,
we observe that the defensive portfolio performed well
in f light-to-quality environments when market vola-
tility was rising. The aggressive portfolio performed best
in risk-seeking environments when market volatility was
low or falling. While factor timing is potentially chal-
lenging, the notion of factor rotation is attractive to
many investors and many practitioners are investigating

EXHIBIT 14
Historical Evolution of the Excess Returns of the Aggressive and Defensive Portfolios vs. the MSCI Worlds
Returns (lhs axis). On the rhs axis, we Show the Behavior of Markets Volatility, as Proxied by the Realized
Volatility of the MSCI World Index

Notes: The above data refers to simulated past performance, which is not a reliable indicator of future performance.
Source: BlackRock, Bloomberg. As of the end of Jan-2015. Based on USD denominated net total return indices.
Our Defensive factor portfolio, denominated in USD, rebalances annually, provides exposure to 50% MSCI World Sector Neutral Quality Index NR
USD and 50% MSCI World Minimum Volatility Index NR USD. Our Aggressive factor portfolio, denominated in USD and rebalances annually,
provides exposure to 33.3% MSCI World Momentum Index NR USD, 33.3% MSCI World Mid-Cap Equal Weighted Index NR USD and 33.4%
MSCI World Enhanced Value Index NR USD. For a full assessment of the investment strategy, the different levels of risk implied by each solutions should
also always be considered. Past performance is not an indicator of future results. Index and portfolio returns do not reflect any management fees, transaction
costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Data for the time periods prior to the index inception date (MSCI
World Minimum Volatility Index NR USD was launched on 14-Apr-2008; MSCI World Momentum Index NR USD was launched on 11-Dec-2013;
MSCI World Mid Cap Equal Weighted Index NR USD was launched on 25-Jul-2014; MSCI World Enhanced Value Index NR USD and MSCI
World Sector Neutral Quality Index NR USD were both launched on 11-Aug-2014) is hypothetical back-tested data. The MSCI World Index was
launched on 31-Mar-1986.

SUMMER 2015 THE JOURNAL OF INDEX INVESTING

both subjective and rules-based methods of dynamic timing as one factor may perform well just as another
factor allocations. is struggling.
Bull market periods are identified as follows: A simple base case for the construction of a multi-
Period 1: Mar-2003 to Oct-2007. Period 2: Apr-2009 factor portfolio is equal weighting across factors. In
onwards to Jan-2015. The financial crisis in the U.S. Exhibit 15, we examine an equally weighted combi-
and the accompanying crash in global equity markets nation of four MSCI World Factor indices to repre-
between Nov-2007 and Mar-2009 are identified as a sent exposures to value, quality, momentum, and size,
bear markets. compared to the MSCI World Index. Based on simu-
In contrast to the case examined above, many lated past performance, in each of the 1-year, 3-year
smart beta investors seek well-diversified smart beta and 5-year periods examined ending 31-Mar-2015,
strategies that can offer the potential for incremental the equally weighted combination of factors provides
returns, perform well in a variety of market condi- positive incremental returns. Exhibit 15 also includes
tions and logically complement traditional index or the historical returns for the MSCI World Diversified
active equity strategies. For investors seeking broadly Multi-Factor Index, which is deliberately constructed
diversified smart beta equity strategies, allocating across to maximize exposure to securities with strong rank-
many style factors can ameliorate the need for factor ings across an equal-weighted combination of value,
quality, momentum, and size criteria.
The historical outperformance of the
MSCI World Diversified Multi-Factor
EXHIBIT 15 Index compared to the combination of
Comparing Multi-Factor Portfolio Approaches single-factor indices ref lects the efficiency
gain inherent in its portfolio construc-
tion. A unif ied portfolio construction
process allows the index to take advantage
of netting opportunities across securities:
the long-only constraint is applied only
once, taking into consideration all avail-
able information about potential risk and
return. In contrast, single-factor indices
are by def inition constructed without
reference to each other. A momentum
index may overweight the same stock
that is underweighted in a quality index.
For multi-factor investors, simultaneously
trading off style metrics means a more
efficient spend of risk on those securities
that exhibit the highest combined ranking
Source: BlackRock, Bloomberg. As of the end of Mar-2015. The MSCI World Factor Equal across the desired style dimensions.
Weight Portfolio is a simulated portfolio, denominated in USD and rebalances annually, pro-
vides exposure to 25% MSCI World Sector Neutral Quality Index NR USD, 25% MSCI
World Momentum Index NR USD, 25% MSCI World Enhanced Value Index NR USD CONCLUSION
and 25% MSCI World Mid-Cap Equal Weighted Index NR USD. Past performance is
not an indicator of future results. Index and portfolio returns do not reflect any management
fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in Smart beta strategies deviate from
an index. Data for the time periods prior to the index inception date (MSCI World Momentum traditional indices by definition, and result
Index NR USD was launched on 11-Dec-2013; MSCI World Mid Cap Equal Weighted in implicit or explicit biases towards cer-
Index NR USD was launched on 25-Jul-2014; MSCI World Enhanced Value Index NR
USD and MSCI World Sector Neutral Quality Index NR USD were both launched on
tain factors. Smart beta strategies therefore
11-Aug-2014; MSCI World Diversified Multi-Factor Index was launched on 19-Mar-2015.) represent a powerful set of tools to seek
is hypothetical back-tested data. The MSCI World Index was launched on 31-Mar-1986. incremental performance, reduce risk,
or enhance diversification along factor

SMART BETA STRATEGIES AS OUTCOME-ORIENTED SOLUTIONS IN THE EQUITY SPACE SUMMER 2015
dimensions. We encourage smart beta investors to con-
sider their own goals and unique needs when evaluating
potential strategies.
What is the objective of the potential smart beta
strategy: return enhancement or risk mitigation?
What is the investors risk tolerance and time
horizon? How much cyclicality can the investor
endure Understanding what the bad times
may look like can help investors withstand those
uncomfortable times.
What is the investors expectation for the future,
including market returns and the persistence of
style factors? How prominent a role should these
views take in the formulation of the investment
strategy?
As we have shown, the portfolio construction
decisions surrounding index methodology can have a
significant impact on a strategys risk and return results.
As with any investment strategy, its underlying charac-
teristics will drive its behavior along with the ultimate
success and durability of the investment strategy. We
firmly believe that there is a valuable role for smart beta
alongside traditional index and active investing.
ENDNOTES
BlackRock Advisors (U.K.) Limited, which is autho-
rized and regulated by the Financial Conduct Authority
(FCA), having its registered office at 12 Throgmorton
Avenue, London, EC2N 2DL, England, Tel +44 (0)20 7743
3000, has issued this document for access by Professional Cli-
ents only and no other person should rely upon the informa-
tion contained within it. For your protection, calls are usually
recorded. Investment in the products mentioned in this docu-
ment may not be suitable for all investors. Past performance is
not a guide to future performance and should not be the sole
factor of consideration when selecting a product. The price
of the investments may go up or down and the investor may
not get back the amount invested. Hypothetical data results
are based on criteria applied retroactively with the benefit of
hindsight and knowledge of factors that may have positively
affected its performance, and cannot account for risk factors
that could affect any actual fund performance. Any actual
fund performance could vary significantly from the hypo-
thetical index performance due to transaction costs, liquidity
or other market factors. BLACKROCK, BLACKROCK
SOLUTIONS, iSHARES, BUILD ON BLACKROCK,
summer 2015
SO WHAT DO I DO WITH MY MONEY and the styl-
ized i logo are registered and unregistered trademarks of
BlackRock, Inc. or its subsidiaries in the United States and
elsewhere. All other trademarks are those of their respective
owners.
1
Source: BlackRock Investment Institute, BlackRock
ETP Landscape, Simfund. Data excludes assets in Cayman
Islands, British Virgin Islands, and Bermuda-domiciled funds.
As of the end of December 2014. Throughout this docu-
ment, ETF data is referenced from a number of sources by
BlackRock including provider websites, fund prospectuses,
provider press releases, provider surveys, Bloomberg, the
National Stock Exchange, Strategic Insight Simfund, Wind,
and the Bank of Israel. Mutual fund data is sourced from
EPFR.
2
As at the end of December 2014. By retail asset man-
agement industry we define the aggregation of ETP with
index and active mutual funds offered to retail clients.
3
In 1884, Charles Dow and Edward Davis Jones began
to list the Dow Jones Average index: a price-weighted bench-
mark of 11 U.S. railways companies.
4
BlackRock estimates, based on number of indices
maintained by a sample of index providers as of March 2015.
Providers included: MSCI, FTSE, Stoxx, and S&P.
5
With the exception of the Nikkei 225 Stock Average
index, which is used as the default choice to represent the
Japanese equity market and which uses a price weighting
scheme.
6
Which we review in the following section.
7
Both investment vehicles were tracking indices with
underlying securities selected on a basis of a range of fun-
damental values and combined using a modified equally
weighted methodology. This meant that out of a total of 50
stocks, the top 15 constituents were given 50% of the weights
(equally distributed) and the remaining 35 constituents were
contributing for 50% weight (again, equally distributed).
8
Source: BlackRock, as of March 2015.
9
Source: BlackRock, ETP Landscape as of end of March
2015.
10
Calculated from January 2010 to December 2014.
11
By this we define ETFs that track an index whereby
the constituents are weighted based on the historical or pro-
spective estimated dividend paid.
12
Source: BlackRock, as of March 2015.
13
Source: BlackRock, as of March 2015.
14
Source: BlackRock, as of March 2015.
15
Source: BlackRock, as of March 2015.
16
As implied by its name, this latter index invests in
the same 500 companies included in the traditional index,
however, each of them has the same weight in the bench-
mark index.
The Journal of Index InvesTIng
 17
While we classify minimum-volatility strategies as Baker, M., B. Bradley, and J. Wurgler. Benchmarks as Limits
part of factor strategies, we cover them in a dedicated section to Arbitrage: Understanding the Low Volatility Anomaly.
given their popularity among ETP investors. (March 2010). NYU Working Paper No. FIN-10-002. Avail-
18
In low-volatility strategies, constituents weights able at SSRN: http://ssrn.com/abstract-1585031.
are inversely correlated to the stocks volatility. Minimum
variance and minimum-volatility strategies are generally Bender, J., R. Briand, D. Melas, and R.A. Subramanian.
optimized to seek the risk minimizing portfolio subject to Foundations of Factor Investing. MSCI Research Insight,
a number of constraints related to turnover, liquidity, posi- (2013).
tion sizes, and country or sector mid-weights. Despite having
similar names, these methodologies that result in very dif- Bender, J., R. Briand, D. Melas, R.A. Subramanian, and
ferent portfolios with very different behaviors. M. Subramanian. Deploying Multi-Factor Index Allocations
19
Among indexed minimum-volatility strategies avail- in Institutional Portfolios. MSCI Research Insight, (2013).
able, some of the most advanced ones employ optimization
processes which are aimed at selecting a subset of stocks from Cohen, S., and U. Marchioni. The Art of Indexing, Black-
the investible universe with minimum volatility, under cer- Rock, (2014).
tain constraints. This optimization process typically considers
the volatility of each stock and the correlation between stocks, ETP Landscape. March 2015, BlackRock.
and delivers strategies that are very close to the equivalent
capitalization-weighted index (the parent index) in terms
of sector, country, and factor exposuresexcept for the vola- BIBLIOGRAPHY
tility factor. This aims to achieve an exposure with lower
absolute risk, without deviating substantially from the char- Carhart, M. On Persistence of Mutual Fund Performance.
acteristics of the parent index. Journal of Finance, 52, (1997) pp. 57-82.
20
With reference to Baker et al. [2010].
21
Style factors have been heavily researched in academic Fama, E.F., and K.R. French. The Cross-Section of Expected
literature. Rosenberg and Marathe were among the first to Stock Returns. Journal of Finance, Vol. 47, No. 2 (1992).
describe the importance of style risk factors in explaining stock
returns. Fama and French put forward a model explaining . A Five-Factor Asset Pricing Model. University of
U.S. equity market returns with three factors: the market Chicago, Amos Tuck School of Business, Dartmouth Col-
(based on the traditional CAPM model), the size factor (large lege, (2014).
versus small capitalization stocks), and the value factor (low
versus high book to market). The Fama-French model, Kahn, R.N., and M. Lemmon. Making Smart Decisions
which now includes Carharts momentum factor has become About Smart Beta. (2014).
a trademark within factor investing.
22
This category includes minimum-volatility, low vola- . Who Should Buy Smart Beta? BlackRock, (2014).
tility, and minimum-variance strategies.
23
Source: www.msci.com. Global Investable Markets Keynes, J.M. General Theory of Employment, Interest, and
Value and Growth Index Methodology, December 2007. Money. Macmillan Cambridge University Press, for Royal
MSCI Value Weighted Indices Methodology. August 2012. Economic Society, (1936).
MSCI Enhanced Value Indices Methodology. August 2014.
Exhibit 5 containing cross-correlations of various style factor Rosenberg, B., and V. Marathe. Common Factors in Secu-
returns. rity Returns: Macroeconomic Determinants and Macroeco-
24
As observed in Bender et al. [2013]. Deploying nomic Correlates. University of California, (1976).
Multi-Factor Index Allocations in Institutional Portfolios.
MSCI Research Insight. Schoenfeld, S.A. Active Index Investing. Wiley Finance,
(2004).
REFERENCES

Antropova, S., and R. Tiwari. Factoring in Stock DNA. To order reprints of this article, please contact Dewey Palmieri
BlackRock, (2015). at dpalmieri@ iijournals.com or 212-224-3675.

SMART BETA STRATEGIES AS OUTCOME-ORIENTED SOLUTIONS IN THE EQUITY SPACE SUMMER 2015