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How Smart is ‘Smart Beta’?

Written by David Blitz

February 22, 2013

The efficiency of alternative index approaches


Although momentum strategies have shown impressive long-term average returns, they can show a large underperformance over shorter periods of time. For example, the generic long-short momentum strategy shows a return of -83 percent over the year 2009.15 In our view, the main challenge involved with harvesting the momentum premium is how to control the high risk involved with the strategy. AQR, which recently introduced the first serious momentum indices, does so by limiting the tilt towards momentum stocks. Specifically, they invest in a relatively broad set of stocks (the top 33 percent based on a ranking on return over the past 12 months, excluding the most recent month) and they weight these stocks in proportion to their market capitalisation. Although these choices are indeed effective for controlling a momentum strategy risk, they also prevent investors from benefiting from the momentum premium’s full potential magnitude.

To earn the momentum premium it is not necessary to be exposed to the large risks involved with naïve momentum strategies. Specifically, a more sophisticated momentum strategy is highly effective at eliminating precisely those risks that are not properly rewarded, thereby resulting in significantly better risk-adjusted returns.16 The essence of our approach is to adjust the momentum of each stock for the part that is driven by its systematic risk characteristics (for example, high-beta stocks are expected to outperform the market in proportion to their beta). By ranking stocks according to their remaining, idiosyncratic momentum we obtain a more sophisticated momentum strategy, which is much less sensitive to systematic risk, such as a broad market reversal. This enables us to create a portfolio which is tilted more aggressively towards the momentum premium, whilst staying within the same risk budget.

Turnover is also a major concern with momentum strategies, which have relatively high turnover by definition. From this perspective, the AQR momentum indices are clearly not entirely optimal, because they may involve buying a stock ranked just above the selection threshold and selling it at the next rebalancing, three months later, if its rank has dropped to just below the selection threshold. More sophisticated buy-sell rules may be able to avoid such unnecessary turnover.17

Equally weighted indices
Several index providers, including MSCI and S&P, have introduced equally weighted indices. These are typically regarded as a means to harvest the small-cap premium. However, we believe that a word of caution is appropriate here. The evidence for a small-cap premium mainly concerns the smallest, least liquid stocks. Equally weighted indices do not actually invest in these stocks, but continue to invest in large and medium-sized firms. For example, the S&P 500 Equal Weight index still invests in the 500 largest US stocks, while the total number of US stocks is well over 5,000. Thus, equally weighted indices are better described as strategies that try to exploit a possible difference in return between large stocks and even larger stocks. Equally weighted indices are thus able to profit only partly, at best, from the small-cap effect.

Another concern with equal weighting is that portfolio weights move continuously away from their target levels, so frequent rebalancing is required to maintain equal weights. As this rebalancing involves selling recent winners and buying recent losers, this goes against the momentum effect. A nice anecdote in this regard is that back in the early 1970s, when the concept of passive investing was conceived, some of the early adopters chose equally weighted portfolios, but soon abandoned this approach.18 In our view, a traditional capitalisation-weighted (buy-and-hold) index of true small stocks is a more appropriate and a more efficient way to capture the small-cap premium.

In smart beta indices, such as fundamental and minimum-volatility indices, stock weights are based not on their market capitalisations, but on some alternative formula. The added value of smart beta indices comes from systematic tilts towards classic factor premia that are induced by these alternative weighting schemes. Smart beta indices are not specifically designed for harvesting factor premia in the most efficient manner, but primarily for simplicity and appeal. For a number of popular smart beta indices we have discussed the main pitfalls, and how investors may capture factor premia more efficiently by addressing these concerns. Finally, it is important to remember that although passive management can be used to replicate smart indices, investors should realise that smart indices themselves always represent active strategies.


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