How Smart is ‘Smart Beta’? 

February 22, 2013 
Page 3 of 6
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 lowconviction 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 exUS 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. LowVolatility indices 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 riskreturn profile to more sophisticated optimisation approaches.^{10} The added value of both approaches comes from their tilt towards lowvolatility stocks, which enables them to capture the lowvolatility premium.^{11} We believe, however, that both represent a suboptimal way of benefiting from the lowvolatility premium. Our first concern with lowvolatility indices is their onedimensional view of risk, focusing mainly on past volatility and correlations. Risk cannot be captured by a single number, and our research confirms that a multidimensional approach, which also includes forwardlooking risk measures, is able to reduce risk—in particular tail risk—further.^{12} A second concern with lowvolatility 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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JOURNAL OF INDEXES EUROPE
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