Beta describes the return achieved from exposure to the overall market, e.g., via an index fund. It is also a measure of the relative volatility of a stock compared to the whole market.

Stock index futures, especially E-mini S&P 500 futures, are the institutional choice for beta replication and can allow investors large and small to achieve the elusive goal of cheap beta. Beta can now be sourced efficiently and cheaply around-the-clock in nearly any major stock index.

The market in this case is the S&P 500. If a stock has a beta of 1.20, it is 20% more volatile than the S&P 500. If the S&P 500 was up 10%, a stock with a beta of 1.20 would be expected to rise by 12%.  If a stock has a beta of .80, it is only 80% as volatile as the whole market. If the S&P 500 advanced by 10%, a stock with a beta of .80 would be expected to rise only 8%.  

An S&P 500 Index fund, which owns each of the 500 members of the index, has a beta of exactly 1.00. Hence, if an investor was “buying beta,” it would refer to investing in the whole market, usually through derivatives such as S&P 500 futures. If an investor wanted exposure to small cap beta, he might obtain this through E-mini Russell 2000 futures.

Futures are a cheap and efficient way to obtain beta exposure. In fact, investors can replicate exposure in just about any type of market.

While other sources for beta replication (swaps/options/ETFs) exist, futures offer the best combination of efficiency, liquidity and low transaction costs.

The latest evolution in passive investing goes beyond plain vanilla passive investing. Smart beta is an approach that tries to enhance the return from tracking an asset class by deviating from the traditional cap-weighted approach, in which investors simply buy shares or bonds in proportion to their market value in their respective index.  

Fundamental indexing, where each component stock might be weighed according to their earnings or price-to-sales ratios, are part of many smart beta strategies.

Equal-weighted indices are another strategy and can help prevent overweighting caused by the most successful stocks in an index. As time progresses, successful companies can become over-weighted in their indices. This can cause balance issues and a portfolio that is biased toward the successful larger-cap companies.

As fundamental indexing and new generations of beta appear, look for more innovative products going forward including futures contracts and derivatives on such products.