How Smart is ‘Smart Beta’?
|February 22, 2013|
Page 4 of 6
We also observe some significant differences in the composition of different low-volatility index portfolios. The S&P 500 Low Volatility index does not constrain sector weights, resulting in a huge sector concentration. For example, at the time of writing around 60 percent of this index invested in only two sectors (utilities and consumer staples). The MSCI Minimum Volatility index, on the other hand, does not allow sector weights to deviate more than 5 percent from their weight in the regular, capitalisation-weighted index. In our view, both approaches are too extreme. The MSCI Minimum Volatility index is overly constrained, while the S&P 500 Low Volatility index is overly concentrated. Our assessment is that the optimum lies somewhere between these two approaches.
Russell recently launched its so-called “defensive” equity indices, which can be regarded as a “low-volatility light” alternative. This is because the weight of low-volatility factors in these indices amounts to only 50 percent. The other 50 percent is based on “quality” factors, such as earnings stability, profitability and leverage. The reason for blending in these other factors is not entirely clear. The back-tested index returns indicate that these factors increase, rather than reduce volatility. So if volatility does not improve, the benefit should probably come from improved returns. Thus, investors should be convinced that the incremental return from tilting towards quality more than offsets the higher volatility induced by these factors.
Maximum Sharpe ratio indices
The Maximum Diversification and Risk Efficient indices are often regarded as alternative low-volatility approaches. To understand this, note that lowering portfolio volatility helps to maximize the Sharpe ratio, which has volatility in the denominator. However, the indices actually go against the low-volatility premium by assuming that expected returns are proportional to (downside) volatility, which makes high-risk stocks more attractive in the numerator of the Sharpe ratio. These two opposing forces, i.e. a preference for low-volatility stocks from a risk perspective versus a preference for high-volatility stocks from a return perspective, can cause the indices to have either a low-volatility or a high-volatility profile. In the long-term, the high-volatility profile actually dominates.13 Compared to the capitalisation-weighted index, the indices also appear to load on the small-cap and value factor premia.14
To sum up, classic factor premia fully explain the added value of the Maximum Diversification and Risk Efficient indices. Unlike fundamental and minimum-volatility indices, however, the tilt towards factor premia is less direct and more dynamic in nature.