8846 how smart is smart beta


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How Smart is ‘Smart Beta’?

Written by David Blitz

February 22, 2013

The efficiency of alternative index approaches

Worldwide, investors are increasingly keen on “smart beta” investing. By this we mean passively following an index in which stock weights are not proportional to their market capitalisations, but based on some alternative weighting scheme. Well-known examples of smart beta include fundamentally weighted and minimum-volatility indices.

In this article, we first take a critical look at the pros and cons of smart beta investing in general. After this, we discuss the most popular types of smart indices that have been introduced in recent years. The added value of smart beta indices has come from systematic tilts towards classic factor premia that are induced by their weighting schemes. We will argue that investors should be aware of the potential pitfalls of smart beta indices, which arise because they are not specifically designed for harvesting factor premia in the most efficient manner, but primarily for simplicity and appeal. Although passive management can be used to replicate smart indices, it is important for investors to realise that, without exception, smart indices themselves represent active strategies.

Smart beta investing in general
The argument which is typically used to motivate smart beta investing is that the capitalisation-weighted index is inefficient, and that a more efficient portfolio can be constructed by applying some alternative stock weighting scheme. Investors should understand, however, where the added value of such weighting schemes really comes from. Research has shown that the weighting schemes used by alternative indices result in structural tilts towards stocks which score high (or low) on certain factors, and that the premia which are known to be associated with these factors are driving performance.1 For example, when compared to the capitalisation-weighted index, fundamental indices have a systematic tilt towards value stocks. These exposures enable the strategy to benefit from the well-known value premium, which, in fact, turns out to fully explain its performance. Similarly, a minimum-volatility index captures the low-volatility premium by tilting the portfolio towards low-volatility stocks. Although this may seem obvious to some, many smart beta index providers are still reluctant to acknowledge factor exposures drive their performance, and that their weighting schemes are merely a novel way of establishing exposures towards classic factor premia.

We are often asked whether smart beta investing is a form of passive investing. It is important to realise that it is not. Although passive management can be used to replicate smart indices, smart indices themselves are essentially active strategies. The only truly passive investment strategy is the capitalisation-weighted broad market portfolio, which represents the only buy-and-hold portfolio that could, be held in equilibrium by every investor. Smart beta indices are fundamentally different because they require various subjective assumptions and choices. Their active nature is also illustrated by the fact that they require periodic rebalancing to maintain their profile. Smart beta indices may bear some resemblance to true passive investing, for example by investing in a large number of stocks with relatively low turnover, but their deviations from the capitalisation-weighted index, which are the key to their added value, represent active investment decisions.

Smart beta investing is a way to tilt a portfolio actively towards certain factor premia. As we are proponents of factor investing, this makes smart beta investing a potentially promising investment approach. For example, in a recent paper we argued that equity investors should strategically allocate a sizable part of their portfolio to the value, momentum and low-volatility factor premia.2 Smart beta investing represents one way in which this could be implemented.


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