US-based Research Affiliates has been involved in smart beta since its inception. The global award winner was the originator of the fundamental indexation approach, selecting and weighing stocks based on their economic footprint rather than their market capitalisation.

Smart beta strategies – narrowly defined to include only those that break the link between market-cap, or price, and portfolio weightings – offer the potential for better-than-market returns, previously only available through active management. They also offer the benefits of traditional index-linked strategies, which include broad market exposure, transparency and rules-based implementation as well as charging fees very nearly as low.

In a low-yield, slow-growth world, investment innovations such as smart beta can be a valuable addition to investors’ long-term financial toolkit.

When the RAFI Fundamental Index, Research Affiliates’ flagship smart beta strategy, was introduced in 2006 it was well ahead of the concept gaining broad industry recognition. The index was presented as the first low-cost, transparent and scalable investment strategy to break the link between price and weight.

“It emphasises breaking the link with price, weighting companies by sales, cash flows, and dividends rather than by market value,” says Rob Arnott, CEO of Research Affiliates. “This attribute was the inspiration for Towers Watson when it coined the label smart beta. Since being introduced the strategy has established an 11-year track record, beating the cap-weighted market index during a decade that has been brutal for value strategies and value managers.”

As of March 2016, RAFI indices are trusted as the underlying foundation for over $120bn in smart beta strategies across ETFs, commingled funds, managed accounts and mutual funds around the world. Arnott points out that RAFI has more capacity, with lower turnover and trading costs, than other strategies in the smart beta arena.

Over the past decade, a plethora of competing ideas have emerged; sadly, says Arnott, the smart beta label has been stretched to encompass many ideas that do not sever the link between a stock’s price and its weight in the portfolio. “For example, I don’t think of most factor tilts – unless they’re pretty extreme – as smart beta. If the term smart beta is expanded to span almost every non-cap-weighted strategy, the term eventually means nothing.”

For Research Affiliates, the clue is in the name. All its beliefs, ideas, and strategies are driven by extensive research. “Our research capabilities are the essential foundation of our business model. We license our ideas to others, and we subadvise,” says Arnott.

It does not directly manage assets and has no trading desk, no back office, and no client reporting capabilities. “Bluntly, our distribution partners don’t need us unless we’re leveraging their own R&D and product innovation capabilities. We must understand the nuances – and the dangers and pitfalls – of all our strategies, and many competing products, in order to justify our keep.”

It does not associate with any strategy it believes will not provide long-term excess return. Ideas must be robust across products, geographies and time periods, says Arnott. “Practically speaking, implementing these strategies to be liquid and high capacity helps accrue the vast majority of returns to the end investor.”

There are challenges that smart beta investors need to be aware of, such as valuations. Valuations matter in selecting securities, asset classes, managers, funds and strategies – and smart beta isn’t any different.

“Investors need to know that many smart beta strategies have succeeded mainly because they have become more expensive,” says Arnott. “Rising valuation levels inflate past performance, creating implausible return expectations for investors looking forward. For the most stretched strategies, any mean reversion back down to historical valuations will cause wonderful past alpha to flip into becoming negative future alpha. Investing when relative valuations are at an extreme is classic performance chasing, a wealth-destroying activity.”