The first generation of index investing started in 1976 when Vanguard launched the first index mutual fund. The objective then was to deliver market-average before-fee returns without the cost of active management. The advent of the second generation can be traced to the publication of “Fundamental Indexation,” an article written by Rob Arnott, Jason Hsu, and Philip Moore that appeared in the Financial Analysts Journal in 2005. The objective of second-generation index investing, known as “smart beta,” is to earn long-term returns on a par with what is expected from traditional active managers, and to deliver those returns well below the cost of active management. The present article explains how and why smart beta strategies can outperform traditional passive management while retaining the desirable qualities of transparency, liquidity, and cost effectiveness.
First-generation index funds track cap-weighted indices, that is, indices whose positions are based on the market capitalization of the constituent stocks. This approach is entirely transparent and allows for low trading costs. Because market capitalization is the arithmetic product of shares outstanding and the market price of a share, cap-weighted indices are directly related to current stock valuations. Given that the number of shares outstanding is fairly stable, cap weighting reduces implementation costs by minimizing turnover; apart from index reconstitutions, when stocks are added or removed, there is no need to buy or sell shares because the issuers’ market capitalizations are automatically adjusted for price changes every trading day.
By the same token, however, funds that track cap-weighted indices hold stocks in greater or lesser proportions as their market values rise or fall. They are therefore prone to hold larger positions in high-priced, possibly overvalued stocks and smaller positions in low-priced, possibly undervalued stocks. This inherently creates a pernicious return drag on the fund and the underlying index alike.
Smart beta indices base weights on factors unrelated to stock prices. For instance, fundamentals-based indices—the prototype of smart beta indices—rank and weight positions by four measures of company size: five-year averages of cash flow, sales, and dividends, and the most recent book value of shareholders’ equity. This simple rules-based scheme preserves transparency, and because the fact-based metrics of accounting size reflect the company’s economic footprint, it also offers high liquidity and limited transaction costs. Both cap-weighted and fundamentals-weighted indices hold stocks in proportion to size, and accordingly, many of the same names appear among their respective top constituents. The indices’ sector and country exposures are also fairly similar; the most notable difference is that sector and country allocations tend to be more stable under the fundamentals-weighted approach.
But here’s the key: by severing the linkage between stock price and position weight, the smart beta approach frees funds from the return drag that cap weighting cannot escape. Relative to cap-weighted indices, fundamentals-weighted indices underweight the stocks that are most in favor and overweight those that are feared and shunned. Incremental returns are achieved as the market corrects misvaluations over the long run. In the best established, most efficient markets, long-term simulations demonstrate that switching from cap-weighted to fundamentals-weighted indices generates, on average, about 200 basis points extra return a year. The step-up is even greater in less-efficient markets.
Smart beta investing has an imbedded value tilt, but differs from active value management in that it does not assume the value premium compensates for some sort of value risk, which is constant over time. Rather, the fundamentals-based index construction methodology benefits from securities being mispriced and the tendency for prices to eventually revert toward their long-term averages. This philosophical point has practical consequences: smart beta investing avoids two basic mistakes commonly made by traditional value managers. The first mistake is assuming it is sufficient to select value companies and cap weight them. Cap weighting gives the smallest allocation to the cheapest stock; if, as the author has found, the return is driven by mispricing, then cap-weighted indices will not derive the full benefit from value stocks’ price appreciation.
The second mistake is that cap-weighted indices and traditional value managers tend to maintain a constant value loading over time. If the value premium is driven by mispricing, it makes more sense to assume the degree of market mispricing can vary—and, indeed, several studies have empirically demonstrated that the value premium is time varying. The fundamentals-based weighting strategy is innately dynamic. It increases the value exposure when the mispricing is greatest and reduces it, becoming more growth-like, when fewer mispricing opportunities are present.
In short, smart beta, the second generation of index investing, no longer seeks to earn average returns; its objective is to achieve excess returns relative to the market, while for the most part preserving the advantages of first-generation indexing—that is, transparency and capacity at a substantially lower cost than active management.
Summarized by Philip Lawton, CFA