1. Research Affiliates did not coin the popular term smart beta. We are using it as a convenient way to refer to non-price-weighted, rules-based investment strategies in which periodic rebalancing is the central mechanism for capturing premium returns.
2. The risk-adjusted returns may differ. For example, over the 1964–2012 period, a portfolio whose stock weights were based on the standard deviation σ of monthly returns over five years (thus, a high-volatility portfolio) had a Sharpe ratio of 0.36. The inverse portfolio whose stocks were weighted by 1/σ (therefore, a low-volatility portfolio) had a Sharpe ratio of 0.47. See Arnott, Hsu, Kalesnik, and Tindall (2013).
3. This does not mean the trades are precisely the same. Different weighting methods will naturally result in somewhat different rebalancing transactions. Portfolios are also likely to operate on different rebalancing schedules.
4. We also looked at full portfolios for a fundamentally weighted and an equal-weighted index and found they executed countercyclical trades (buying underperforming stocks and selling outperforming stocks) in 75% of their stock positions at the latest reconstitution.
5. Bogle (2005), p. 22. Bogle’s emphasis.
6. Because investment managers generally don’t control the timing and magnitude of external cash flows (that is, investors’ contributions and withdrawals), they quite properly report returns on a time-weighted basis. The investors’ experience, however, is reflected by their individual money-weighted returns, which do take external cash flows into account. Kinnel uses industry aggregate cash flow information to estimate the average investor’s actual return. For more information about time-weighted and money-weighted rates of return, see Bailey, Richards, and Tierney (2007), pp. 724–729.
7. See Stewart, Neumann, Knittel, and Heisler (2009) and Goyal and Wahal (2008).
8. We also analyzed the results against an appropriate value style index and found nearly identical results. We chose to show the S&P 500 here because we wanted to display the cyclicality of excess returns against the broad market.
Arnott, Robert D., Jason Hsu, Vitali Kalesnik, and Phil Tindall. 2013. “The Surprising Alpha from Malkiel’s Monkey and Upside-Down Strategies.” Journal of Portfolio Management, vol. 39, no. 4 (Summer):91–105.
Bailey, Jeffery V., Thomas M. Richards, and David E. Tierney. 2007. “Evaluating Portfolio Performance.” In John L. Maginn, Donald L. Tuttle, Dennis W. McLeavey, and Jerald E. Pinto, eds., Managing Investment Portfolios: A Dynamic Process, 3rd ed. Hoboken, NJ: John Wiley & Sons:717–780. Reprinted in Philip Lawton and Todd Jankowski, eds., 2009, Investment Performance Measurement: Evaluating and Presenting Results. Hoboken, NJ: John Wiley & Sons:11–80.
Bogle, John C. 2005. “The Relentless Rules of Humble Arithmetic.” Financial Analysts Journal, vol. 61, no. 6 (November/December):22–35. Reprinted in Rodney N. Sullivan, ed., 2005, Bold Thinking in Investment Management: The FAJ 60th Anniversary Anthology, Charlottesville, VA: CFA Institute:127–144.
Goyal, Amit, and Sunil Wahal. 2008. “The Selection and Termination of Investment Management Firms by Plan Sponsors.” Journal of Finance, vol. 63, no. 4 (August):1805–1847.
Kinnel, Russel. 2014. “Mind the Gap 2014.” MorningstarAdvisor (February 27).
Stewart, Scott D., John J. Neumann, Christopher R. Knittel, and Jeffrey Heisler. 2009. “Absence of Value: An Analysis of Investment Allocation Decisions by Institutional Plan Sponsors.” Financial Analysts Journal, vol. 65, no. 6 (November/December):34–51.