How Smart is ‘Smart Beta’?
|February 22, 2013|
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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
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.