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Key highlights After significant losses by large-capitalization and growth stocks during the 2000-2002 bear market, investors have become increasingly interested in non-market-cap index-weighting strategies that intentionally divorce a security’s index weighting from its price. Such rules-based alternatives to market-cap-weighted indexes include strategies labeled alternative indexing, fundamental indexing or, more commonly used, smart beta. Vanguard believes strongly that, by definition, smart beta indexes should be considered rules-based active strategies because their methodologies tend to generate meaningful security-level deviations, or tracking error, compared with a broad market-cap index. Our research shows that such strategies’ “excess return” can be partly (and in some cases largely) explained by time-varying exposures to various risk factors, such as size and style. Place “the market” in front of a mirror and what would you see? A perfect reflection of that market-same size and shape, nothing added, nothing taken away. If you wanted the reflection to show something different from the market-something better?-you’d need to place something different in front of the mirror. That’s the puzzle of smart beta, whose providers often suggest that they’re “like the market,” only better. If you’re looking to get different returns from, for example, the U.K. stock market, “you have to look different in some way, shape, or form,” said Don Bennyhoff, senior investment analyst in Vanguard Investment Strategy Group. “The first thing smart beta providers do is modify what the market looks like, based on their own active choices and biases.” Recent research by Bennyhoff and his colleagues Christopher Philips, Fran Kinniry, Todd Schlanger, and Paul Chin found that the rules-based methodologies employed by alternatives to market-cap-weighted indexes tend to generate meaningful tracking error compared with broad market-cap indexes. The methodologies may weight securities differently from their market-cap weighting. Or they may exclude securities that feature in a benchmark and include securities that aren’t part of the benchmark. “In our opinion,” Bennyhoff said, “these rules-based strategies are active, which means they’re not asset-class beta or ‘the market’ in the traditional sense.” The sources of outperformance “These strategies tend to result in portfolios that emphasize smaller-cap or value stocks, which have performed very well since the early 2000s,” Bennyhoff said. “So the question is, ‘Are these higher returns the result of higher risks?’ There is rigorous debate about that topic. But when we look at risk-adjusted returns, the excess return tends to go away, and maybe that’s a meaningful finding.” Moreover, as the figure below shows, smart beta strategies’ exposures to risk factors change over time. Non-market-cap-weighted strategies’ exposures to risk factors are time-varying 60-month rolling style and size exposure of alternative index versus broad developed-equity market, 1999-2014 Source: Illustration by Vanguard, based on data from MSCI, FTSE, S&P Dow Jones Indices, and Thomson Reuters Datastream. Figure displays 60-month rolling inferred benchmark weights resulting from tracking error minimization for each index across size and style indexes. Factors are represented by the following benchmarks: fundamental-weighted-FTSE RAFI Developed 1000 Index; equal-weighted-MSCI World Equal Weighted Index; GDP-weighted-MSCI World GDP Weighted Index; minimum volatility-MSCI World Minimum Volatility Index; risk-weighted-MSCI World Risk Weighted Index; dividend-weighted-STOXX Global Select Dividend 100 Index. “We’re not saying that paying attention to factors or tilting on value or small-cap is necessarily a bad thing,” Bennyhoff said. “Whether they pay off in the future as they’ve paid off in the past remains to be seen. But instead of putting together a strategy where the factor exposure is a by-product of the weighting scheme or the security-selection scheme, maybe it should be the primary focus .” And if you’re looking to capture the risk and reward of an asset class, Bennyhoff says, “the only way you can reflect that aggregate capital invested in the asset class is through market-cap weighting.” Interested in an overview of smart beta and other rules-based active strategies? Read our research brief . Notes: All investing is subject to risk, including possible loss of the money you invest. Diversification does not ensure a profit or protect against a loss. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income. Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.