|Evaluating Alternative Beta Strategies|
|February 24, 2012|
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Since the first market capitalisation-weighted ("cap-weighted") equity index was introduced by Standard & Poor's in 1923, cap-weighted indexing has become the dominant form of index investing. Today, cap-weighted indices account for the vast majority of assets in index-linked investment products such as ETFs and index funds, as well as trading volumes in exchange-traded and over-the-counter ("OTC") index futures, options and other derivatives.
In recent years, there has been a proliferation of alternatively weighted indices, such as fundamentally weighted indices, equal-weighted indices, and low-volatility indices. Correspondingly, there have been increased debates about the role of alternatively weighted indices (or "alternative beta") in investment portfolios.
While some proponents of alternative beta criticise market capitalisation-weighted indices as "inefficient", most market participants believe that market-cap weighting will always be the dominant form of indexing. It is not only the most representative of the market, but also has the lowest implementation cost due to its investment capacity and automatic self-rebalancing. In addition, as the cap-weighted portfolio is the only portfolio that all investors can collectively hold, it represents the ultimate benchmark, where outperformance and underperformance become a zero-sum game relative to the market.
The key to understanding alternative equity beta strategies is the extensive empirical evidence that stock returns are driven not just by the overall market factor, but also by other common risk factors that are related to the characteristics of the stocks. Notably, small-cap stocks and value stocks have historically acted differently from large-cap stocks and growth stocks, respectively, and have generated higher long-term returns.
Fama and French (1992, 1993) found that a three-factor model of market, small-cap and value factors would explain more than 90% of diversified portfolio returns, which significantly improved the explanatory power of a single-factor model, such as the Capital Asset Pricing Model (CAPM). Many studies (e.g. Jegadeesh and Titman (1993) and Carhart (1997)) identify momentum as another common equity risk factor, due to the persistency in the relative performance of past winners and past losers. Last but not least, empirical research (e.g. Haugen and Baker (1991) and Clarke, Silva, and Thorley (2006, 2010)) has shown that an equity portfolio's exposure to the volatility factor can also have significant impact on its risk and return; and, contrary to finance theory, holding high volatility stocks has not been compensated by higher long-term returns than holding low-volatility stocks. To a certain degree, this range of empirical evidence has motivated attempts to achieve better risk adjusted returns than the market capitalisation-weighted portfolio, by tilting a portfolio's exposure to certain common equity factors, such as small-cap, value, and volatility.
Figure 1 shows the historical return and volatility over the last 30 years of these most recognised equity factors for the US equity market. The market factor represents the excess return from investing in the cap-weighted US equity market. The small-cap, value, momentum and volatility factors represent the returns from portfolios that are long small stocks and short large stocks, long high book-to-market stocks and short low book-to-market stocks, long past winners and short past losers, and long high-volatility stocks and short low-volatility stocks, respectively.
It is notable that the small-cap, value and momentum factors have historically been associated with substantial positive returns. If such trends were to continue, this implies that portfolios that systematically overweight small-cap, value and momentum stocks can outperform the market. On the other hand, as the volatility factor has historically had negative returns, portfolios with a tilt to low-volatility stocks would have been better rewarded than the market.