The traditional choice: active vs. passive
In the past, equity investors had two choices. Those who believed markets were largely efficient, or doubted their ability to select skillful managers, leaned toward low-cost capitalization-weighted index funds. Those who believed markets were inefficient and had confidence in their manager selection process were more inclined to opt for active management.
But both approaches are flawed
Both approaches have their drawbacks. Cap-weighted equity index funds automatically increase their exposure to stocks whose prices appreciate and reduce their exposure to stocks whose prices fall. As a result, they tend to overweight overvalued securities and underweight undervalued ones. Our research demonstrates that this built-in pattern creates a 2% return drag in developed markets and more in less efficient ones. But the other choice, active management, is not transparent, comes with high fees, and tends to underperform the benchmark over long time periods.
Related: Smart Beta: The Second Generation of Index Investing
Traditional bond index investing is also flawed
Conventional bond indices give the biggest weights to the biggest debtors. This situation is particularly acute for sovereign bonds, where some developed market nations have sought to drive down yields, creating inefficiencies in the market and failing to reward investors for the risks they are taking. Smart beta strategies additionally offer corporate and sovereign bond investors a transparent, systematic, low-cost alternative to active management.
Related: Smart Beta for Corporate Bonds
Smart beta strategies offer a third choice
As non-price-weighted indices, smart beta strategies offer investors a third choice. These strategies retain the benefits of traditional capitalization- or market-value-weighted approaches, such as broad market exposure, diversification, liquidity, transparency, and low cost access to markets. At the same time, they have the potential to achieve results that are superior to the market returns of cap-weighted benchmarks at lower cost than active management.*
Smart beta strategies can be simple or complex
Smart beta strategies can be constructed with heuristic weighting methods, using simple and sensible rules. Or they can be built with optimization-based weighting methods, which are complex and subject to errors in estimating returns and covariances.
Heuristic based vs. optimized strategies
Popular heuristic-based weighting policies include equal weighting, fundamentals weighting, risk-cluster equal weighting (where risk clusters, instead of individual stocks, are equal-weighted), and diversity weighting (which combines equal weighting and cap weighting). Popular optimized strategies include minimum variance, maximum diversification, and risk efficient indices.
Related: A Survey of Alternative Equity Index Strategies
Strategies outperform the cap-weighted benchmark
A 2011 research paper by Chow, Hsu, Kalesnik, and Little demonstrated that all of these smart beta methodologies produce simulated excess returns compared to the cap-weighted benchmark over long periods of time. Moreover, a 2013 paper by Arnott, Hsu, Kalesnik, and Tindall showed that non-cap-weighted investment strategies and their inverses similarly produced superior hypothetical results. In both cases, the authors concluded that each of these strategies shares the same vital investment insight—they all break the link between market prices and index weights. Seen from the perspective of multifactor investing, the smart beta strategies inherently have value and small size loadings relative to cap-weighted benchmarks. Thus, investors should look closely at implementation costs, such as excess turnover, reduced liquidity, and decreased investment capacity, in choosing a strategy.
Related: What Makes Alternative Beta Smart?
Low volatility stocks: a different take on risk
Like other smart beta strategies, constructing a portfolio of low-volatility stocks breaks the link between price and weight. Research shows that, on average, “pure” low volatility portfolios should earn a long-term return premium of about 2% in the United States with about 25% less absolute risk than the benchmark. However, these strategies tend to have high tracking error against broad market indices.
Related: Making Sense of Low Volatility Investing
Tracking error vs. risk-adjusted returns
One of the essential challenges investors face is deciding whether they are more concerned about “relative risk,” which is measured by tracking error versus a benchmark, or about total risk, expressed as the portfolio’s standard deviation of returns. The Sharpe ratio, a measure of risk-adjusted return, takes total risk into account. Simulated low volatility strategies generally produce attractive long-term risk-adjusted returns.
Related: Smart Beta Series Part 4—Smart Beta and Benchmark Risk
Combining smart beta strategies
It is difficult for a single portfolio to meet both relative risk and total risk expectations. However, because the simulated returns of smart beta strategies are imperfectly correlated, it is possible to combine portfolios with different factor exposures so as to manage the trade-off between expected tracking error and total risk-adjusted performance. For example, investors can combine value, low volatility, and momentum loadings in various proportions to create overall portfolios with desirable expected risk/return profiles.
Related: Building a Better Beta: Combining Fundamentals Weighting,
Low Volatility, and Momentum Strategies
*The opportunity for outperformance may only exist under certain market conditions and over certain periods of time, both of which may vary from historical evidence or research showing such outperformance.