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How Smart is ‘Smart Beta’?

Written by David Blitz

  
February 22, 2013

The efficiency of alternative index approaches

 

Our view on smart beta investing can be summarised as follows: although smart beta investing may be a good start,investors can do better. The reason is that the main appeal of smart beta indices, namely their simplicity, is at the same time their biggest weakness. Specifically, the simple tilts towards factor premia provided by smart beta indices often involve significant risks that are undesirable. In addition, smart beta strategies can be inefficient from a turnover perspective, or can have unattractive exposures to factor premia other than the one(s) specifically targeted.

Another concern with smart beta indices is that they are often based on back-tests which only go back 10 or 15 years in time. Investors should therefore be careful to avoid chasing recent performance. To properly understand the behaviour of a smart index in different environments, we recommend analysing its performance over long historical periods, covering multiple economic cycles. Investors should also carefully think about whether the factor premia driving historical smart beta index returns are likely to persist in the future.

In the following sections we will elaborate on these points by discussing the pros and cons of the most popular types of smart beta indices.

Fundamental indices
In a fundamental index, stocks are weighted in proportion to their fundamentals, such as book value or earnings. In other words, instead of letting the market decide on a stock’s appropriate weight, one might say that fundamental index investors prefer to rely on the assessment of accountants. The differences in weights between a traditional, capitalisation-weighted index and a fundamental index are, by definition, entirely due to differences in valuation ratios of individual stocks. Compared to the capitalisation-weighted index, a fundamental index is tilted towards stocks which are cheap on such ratios, i.e. value stocks. Studies have shown that the added value of fundamental indices is, in fact, entirely attributable to this tilt towards the value premium.3 For a long time, Research Affiliates, the inventors of fundamental indexation, denied that the success of fundamental indexation is critically dependent on a value premium. They argued that random mispricing causes capitalisation-weighted indices to be biased towards overvalued stocks, resulting in a structural drag on performance.4 Nowadays, however, Research Affiliates acknowledges that the value premium explains most, or all of their indices’ performance.5

Our main concern with straightforward value strategies such as fundamental indexation is that they tilt towards financially distressed firms. The share price of a company in financial difficulty falls, and its weight in the cap-weighted index drops correspondingly. Initially, the same happens in a fundamental index. At a certain point, however, a fundamental index rebalances back to the weight based on past and current fundamentals, which have typically not (or only partly) adapted to do the new situation. This exposure to distressed firms might not be a problem if distress risk is the source of the value premium. Studies have shown, however, that the stocks of companies in difficulty underperform and that the tilt to distressed firms of naïve value strategies increases risk.6 This implies that the value premium can be captured more efficiently by avoiding cheap stocks of financially distressed firms.

A related concern is that, since rebalancing involves buying stocks which have recently experienced a large price drop, fundamental indices go against the momentum premium. As the momentum premium is as strong as the value premium, the return of a value strategy may be enhanced by avoiding its natural tendency of going against the momentum premium.

 



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