The neutrality of this article is disputed. (April 2019) (Learn how and when to remove this template message)
Smart beta investment portfolios offer the benefits of passive strategies combined with some of the advantages of active ones, placing it at the intersection of efficient-market hypothesis and factor investing.
Offering an optimal blend of active and passive styles of management, a smart beta portfolio is low cost due to the systematic nature of its core philosophy - achieving optimal efficiency by way of tracking an underlying index (e.g., MSCI World Ex US). Combining with optimization techniques traditionally used by active managers, the strategy can offer risk/return potentials that are more attractive than a plain vanilla active or passive product.
Originally theorized by Harry Markowitz in his work on Modern Portfolio Theory (MPT), smart beta is a response to a question that forms the basis of MPT - how to best construct the optimally diversified portfolio. Smart beta answers this by allowing a portfolio to expand on the efficient frontier (post-cost) of active and passive. As a typical investor owns both the active and index fund, most will benefit from adding smart beta exposure to their portfolio in addition to their existing allocations.
Demand for smart beta
Smart beta strategies have generated considerable interest from institutional investors in the wake of the 2008 financial crisis. According to ETF.com, as of April 2019 there was approximately $880 billion invested in smart beta funds. The increase in demand has led to an increase in the number of products and there are more than 1000 smart beta ETFs on the market today. The demand/growth does not appear to be slowing down; in the 12-month period ending February 2019 77 new smart beta ETFs launched accounting for roughly 1/3 of all ETFs launched in the 12 month period. 
Asset managers including BlackRock, Legg Mason, Henderson Rowe, Invesco and WisdomTree all operate smart beta funds. To identify which type of smart beta provides the best fit, qualified institutional investors need to understand the expected return and risk for each of their active, passive, and smart beta allocations.
Common factor based smart beta types revolve around six ideas for optimization (source: FTSE):
- Liquidity: Amihud ratio – median ratio of absolute daily return to daily traded value over the previous year
- Momentum: residual Sharpe ratio
- Quality: composite of profitability (return on assets), efficiency (change in asset turnover), earnings quality (accruals) & leverage
- Size: full market capitalization
- Value: composite of trailing cash-flow yield, earnings yield and country relative sales to price ratio
- Volatility: standard deviation of 5 years of weekly (wed/wed) local total returns
- MSCI Research Insight Foundations of Factor Investing
- Stewart, James B. (2017-06-22). "An Index-Fund Evangelist Is Straying From His Gospel". The New York Times. ISSN 0362-4331. Retrieved 2017-06-24.
- "What's Working In Smart Beta ETFs | ETF.com". www.etf.com. Retrieved 2019-06-27.
- "1039 Smart-Beta ETF Reports: Ratings, Holdings, Analysis | ETF.com". www.etf.com. Retrieved 2019-06-27.