Investors seek alternatives to market capitalization weighting
The Great Financial Crisis of 2007-2008 and the associated volatility in global equity markets was further evidence – after the Japanese equity bubble of the late 1980s and the dot-com bubble in the early 2000s– that equity risk premium is not paid as evenly over time as investors would envisage. That was bad news for those invested in a passive replication of capitalization-weighted portfolios, and it triggered a search for alternative weighting schemes capable of achieving better riskadjusted performance.
In the past, active management was seen as the means of reaching that goal and a viable route to outperforming the market. However, many investors do not find it easy
to distinguish between the truly skilled managers capable of delivering sustained outperformance and those who may have outperformed out of luck. Selecting skilled
managers is not easy.
What are smart beta indices?
Smart beta indices, based on relatively transparent quantitative methodologies, represent a move away from traditional cap weighting towards alternative weightings purporting to offer either better diversification or greater efficiency than the standard market cap-weighted approach. Historical back-tests of these indices show better risk-adjusted returns than market capitalization indices, often with higher returns and lower risk.
However, smart beta indices should not be regarded as a form of passive investing. Passive management can be used to replicate smart beta indices, but the indices themselves are a form of active investing. Subjective assumptions and choices are required to determine where the emphasis should be. They establish the rules to decide on how to deviate systematically from the market capitalization portfolio, how frequently and by how much. But only the capitalization-weighted portfolio can be
considered as a genuinely passive strategy – it is the only buy-and-hold portfolio that theoretically could be held in equilibrium by every investor.
Why do smart beta indices out-perform?
Over the last years, we have undertaken extensive research into these alternative weighting systems. In fact, we were amongst the first to highlight that risk and returns to smart beta strategies can be almost entirely explained by exposures to risk factors such as value, low volatility, size and momentum, which are known to generate factor premiums in excess of their exposure to the equity risk premium. As demonstrated in a paper published in the Journal of Portfolio Management – Spring 2012, risk and returns of a class of smart beta strategies known as riskbased strategies, which include minimum variance, maximum diversification and risk parity, are derived from exposures to the low volatility factor and in the case of risk parity also to the size factor, and to a smaller extent to the value factor.
This evidence has been confirmed by a number of other researchers since then(1). Fundamental indexing, another type of smart beta strategy, has also been shown to derive its excess returns from exposures to factors, in particular, the value factor.Download to read more