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How Smart is ‘Smart Beta’?

Written by David Blitz

February 22, 2013

The efficiency of alternative index approaches


Another concern with fundamental indices is their sensitivity to settings choices. For example, in certain calendar years, the arbitrary choice of the annual rebalancing moment of the FTSE/RAFI fundamental indices can make the difference between an outperformance of 10 percent or a small underperformance.7 The more recently launched fundamental indices of MSCI, called MSCI Value Weighted indices, address this concern by rebalancing every six months, while those of Russell rebalance a quarter of the portfolio every quarter. In light of these developments, FTSE has decided to provide a staggered quarterly rebalanced variant of the FTSE/RAFI indices in 2013, although these will not replace their current indices but will coexist with them.

Fundamental indices represent a low-conviction approach to capturing the value premium. To understand this, note that a fundamental index is not concentrated in stocks with the most attractive valuation characteristics. For example, the FTSE/RAFI US and Developed ex-US indices each invest in 1,000 stocks, and the MSCI Value Weighted indices invest in all the stocks in the regular MSCI indices. In other words, stocks with the least attractive valuations are still included in these indices, only with smaller weights.

Low-Volatility indices
Low-volatility indices are designed to benefit from the low-volatility premium: the empirical finding that low-risk stocks have similar or better returns than the market average, with substantially lower risk. Minimum-volatility indices use optimisation techniques to create a portfolio with the lowest expected future volatility. The resulting portfolio consists mainly of stocks with low past volatility, although it may also include some higher-volatility stocks if these help to reduce volatility through low correlations. A drawback of optimised low-volatility indices is their lack of transparency. For example, the most popular minimum-volatility index, the one provided by MSCI, uses the proprietary Barra risk model and optimisation algorithm, and many investors regard the index to be a ‘black box.’ Another concern is that the raw turnover of minimum-volatility strategies is very high. MSCI addresses this concern by imposing turnover constraints8, but this causes a new drawback, namely path-dependency. This means that today’s composition of the MSCI Minimum-Volatility index depends on its past composition; a feature which is undesirable for investors who are interested in a fresh minimum-volatility portfolio because they wish to invest in the strategy from scratch.

A more transparent alternative is provided by the S&P 500 Low Volatility index, which simply invests in the 100 stocks in the S&P 500 index with the lowest volatility over the preceding 12 months.9 Empirical studies have shown that this simple ranking approach results in a very similar risk-return profile to more sophisticated optimisation approaches.10 The added value of both approaches comes from their tilt towards low-volatility stocks, which enables them to capture the low-volatility premium.11 We believe, however, that both represent a sub-optimal way of benefiting from the low-volatility premium.

Our first concern with low-volatility indices is their one-dimensional view of risk, focusing mainly on past volatility and correlations. Risk cannot be captured by a single number, and our research confirms that a multi-dimensional approach, which also includes forward-looking risk measures, is able to reduce risk—in particular tail risk—further.12 A second concern with low-volatility indices is that they completely ignore expected return considerations. There is, in fact, a large dispersion in the expected returns of stocks with similar volatility characteristics.


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