1. Arnott and Kose (2014) define equity smart beta as a “category of valuation-indifferent strategies that consciously and deliberately break the link between the price of an asset and its weight in the portfolio, seeking to earn excess returns over the cap-weighted benchmark by no longer weighting assets proportional to their popularity, while retaining most of the positive attributes of passive indexing.” They further expand on their definition of smart beta as index strategies with the following traits: they are transparent, rules-based, low cost relative to active management, high capacity and liquidity, and well-diversified.
2. Flows Show Investors Favoring Smart Beta, EM ETFs, ETF Trends (April 21, 2014).
3. Market cap-weighted indices, while representative of the overall investment opportunity set, have an inherent flaw. The weights of individual securities are linked to their prices, and cap-weighted indices systematically overweight overvalued securities and underweight undervalued securities. As the price of a security increases, the cap-weighted index favors that security by assigning it an increasingly higher weight in the index. As the price of a security falls, and it becomes more attractive from a valuation perspective, its index weight declines. This results in a return drag of approximately 2% per annum in developed markets, (Arnott, Hsu, and Moore, 2005).
4. Several proposed explanations of the low volatility effect are summarized by Hsu and Li (2013) and Li and Lawton (2014).
5. Volatility is calculated by using daily volatility for the previous five years.
6. While momentum strategies take advantage of a well-known return factor, they do have some drawbacks as investment strategies delivered in a smart beta index construct. The large drawdowns and frequent rebalancing they entail lead to high turnover and transaction costs. Particular attention should be paid to these characteristics when evaluating a smart beta momentum strategy versus active management.
7. Kenneth R. French Data Library.
8. The Sharpe ratio is a measure of performance per unit of risk taken. It is defined as the portfolio return in excess of the risk-free rate divided by the portfolio’s standard deviation. This paper uses the 1-month T-bill return from Ken French’s data library as the risk-free rate. The information ratio is a measure of performance per unit of tracking error. The informa- tion ratio is calculated as the portfolio return in excess of the benchmark return, divided by the portfolio’s tracking error against the benchmark.
9. The market beta, size, and value factors were defined by Fama and French (1992, 1993); momentum by Carhart (1997); and low volatility by Frazzini and Pedersen (2014).
10. Cumulative returns for the period April 1, 1998, to March 31, 2000. Source: FactSet.
11. For investors who seek to maximize their total return with the lowest possible volatility, the Sharpe ratio is an appropriate measure, and the low volatility strategy would serve well as the core strategy (see Table 1).
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