Institutions and wealthy individual investors, after two market crashes since 2000, unappealing Treasury yields and little return on cash, are looking for innovative sources of growth. Many of them are turning to “smart beta” products to find it.

Smart beta—also known as “alternative beta” and “advanced beta,” among other monikers—refers to rules-based investment strategies that do not use conventional market capitalization weights. Smart beta tries to capture a market exposure with less risk and/or more return. Outperformance comes from portfolio construction rather than fundamental stock research or quantitative alpha forecasts.

Smart beta products have emerged as a “third way” between active and passive management styles, said Paul Bouchey, managing director for research at Parametric Portfolio Advisors. “Smart beta is a natural extension to the growth in index-based investing,” Bouchey said.

The sector is relatively small, with less than $150 billion in smart beta funds, but appears to be catching on. State Street Global Advisors reported that smart beta products enjoyed inflows of $15 billion in the first quarter, up 45 percent from a year earlier.

By breaking the link with price, smart beta indexes seek to overcome a major concern associated with cap weighting, where a component’s weight increases as its price goes up and big moves in the prices of the largest stocks can dramatically affect the overall value of the index.

The critical aspect of a smart beta strategy is how the index is constructed. Several approaches clamor for attention, and at present, a “thought war” is underway about which one is best, Bouchey said. The simplest approach is to give each security in the index equal weight, which benefits from the fact that small stocks tend to perform better than large stocks.

Other approaches are more complex. One that has gained traction is fundamental indexing, which weighs each company by its financial characteristics—sales, dividends, assets or cash flow—giving the portfolio a value tilt, but also including growth and core stocks. Schwab Fundamental Index ETFs, for example, use three fundamental factors: adjusted sales, which exclude leverage; retained operating cash flow; and dividends and buybacks.

Some fundamental index providers give equal weight to all financial factors, using the average of each one to come up with the list of stocks in the index. Others assign greater or lesser weights to some factors.

Periodically, these providers review the stocks in an index. They add and subtract stocks, and they rebalance components, adjusting the weights of stocks. The rebalancing can result in somewhat higher turnover costs in mutual funds or ETFs that are based on fundamentally weighted indexes.

Bouchey said smart beta should be used primarily as a replacement or complement to passive equity allocations.

Studies have cast a positive light on the performance of indexes that steer away from cap weighting. The Economist recently reported that a study by the Cass Business School showed alternative indexes not only bettered a cap-weighted index over the long term, but also had a better risk-adjusted return. The Cass study also found that a system that randomly chose constituent weights from stocks beat the market.

Smart beta has the benefit of being transparent, Bouchey said. An investor can clearly see how the strategy is positioned in relation to the benchmark. Bouchey noted, however, that Parametric’s smart beta products aren’t so transparent that other market players can take advantage of its strategy when it adds or deletes stocks. One needs to build a parsimonious structure, he said, that’s “simple but not too simple.”

Bouchey said he expected the equal-weighting strategy to attract the most assets because it’s easiest to understand—a critical consideration for investors battered by the financial crisis. In any case, a big part of his job is to educate prospective investors about smart beta. In Europe, he said, pension funds have shown considerable interest. “There’s a need for risk exposure, but issue is how to reduce volatility,” he said. “This has given impetus to smart beta products.”

In the U.S., Bouchey said, he regularly speaks with both institutions and family offices and wealthy individuals about Parametric’s smart beta products. At present, the firm manages $24 billion in smart beta products out of total firm assets of $111 billion.