Smart beta strategies vs cap-weighted indices

Cap-weighted indices

Jeff Molitor, CIO, Europe, Vanguard

Everyone’s talking about ‘smart beta’ these days. But many investors may not understand that the strategies behind this alluring name represent active bets – not beta. Investors need to recognise and assess the bets they are making in a ‘smart beta’ portfolio just as they would with any active strategy.

The theory of the wisdom of crowds describes how large groups of people can collectively produce solutions to complex problems. Ask a number of individuals how many beans there are in a jar and almost all will be off the mark. But when you add up the guesses, the individual estimation errors tend to cancel each other out and a large enough group will likely give you a pretty good estimate.

Cap-weighted indices tap into this. What underpins them is the collective decision-making process of millions of market participants. At any point in time, the market price by which these indices are weighted represents the consensus evaluation of the market and includes both optimistic and pessimistic views. In the process, they automatically capture any potential factor that investors use to value securities.

Smart beta strategies deliberately deviate from the market consensus. As such, smart beta investing involves some kind of active bet against the broad market. Despite the reality that there is no ‘permanent alpha machine’, the term ‘smart’ suggests that these portfolios represent enduringly superior segments of the broad market. Markets are cyclical and there is a powerful force in regression to the mean. Effective use of smart betas therefore requires an active view on the risk/return outlook of the segment represented by the smart beta in the context of the broad market.

In reweighting individual index components, smart beta funds often introduce sector tilts. For example, many equity funds are more heavily geared towards small-cap stocks, effectively building a portfolio based on their recent outperformance. Basing a portfolio on past performance is rarely a recipe for success and, even if it was, sector tilts can often be achieved through cap-weighted sector funds. Essentially, owners of ‘smart beta’ portfolios need to know when the factors they are betting on are in vogue and when they are not. It is market timing under a different guise and the record of investors who try to time the market is dismal.

In contrast, cap-weighted indexing relies on complex and powerful mechanics to achieve a certain weighting. Its strength lies in the unbiased view it takes of risk-and-reward attributes of a market or market subset and its underlying constituents. Security prices change all the time as new information comes in and investors adjust their expectations. Unlike smart-beta products that rely on a fixed set of previously established rules, cap-weighted indices are dynamic and capture any change in market sentiment instantly and continuously.

Smart beta investors need to time their investment carefully since, by definition, no segment will be permanently in or out of favour. Essentially, most investors using smart beta must believe they are cleverer than the market. The bet is that the subset selected will outperform on an absolute or risk-adjusted basis over the period when the smart beta position is in place. In reality, markets are too efficient to ever really offer magic rules-based bullets. There are simply too many people looking to identify and exploit perceived inefficiencies.

Tempting though it might be, smart beta should never be thought of as a ‘perpetual motion alpha generator’. The rules often define portfolios that represent attractive answers to what would have worked extremely well over recent history. You can compare it to preparing for the last war, which rarely represents a successful way forward. Cap-weighted indices and the neutral, forward-looking portfolios they inform may create less noise, but may represent a better way to invest.

Smart beta strategies

Felix Goltz, Head of applied research, EDHEC-Risk Institute and research director, ERI Scientific Beta

Felix Goltz ERI Scientific Beta

Smart beta, advanced beta, alternative beta or strategy indices are terms coined to describe equity index strategies that generate superior risk-adjusted returns compared to standard market cap-weighted indices.

Market cap-weighted indices have shortcomings due to high levels of concentration in large-cap growth stocks that lead to poor risk-adjusted returns. Smart beta strategies that are able to deliver superior risk-adjusted returns have therefore made inroads into the traditional passive investment sector that uses cap-weighted indices.

The passive segment of the market has seen increased inflows since the start of the global economic crisis at the expense of active and hedge fund managers who have struggled to perform according to expectations. Furthermore, replication of hedge funds and attribution analysis of active funds has revealed that in many cases their performance is driven by the same systematic risk factors that smart beta strategies are designed to deliver. Isolating these sources of risk through smart beta strategies is very useful, with the benefit of considerably lower cost and greater visibility for the investor.

Such smart beta strategies will not be a replacement for cap-weighted indices, which will remain the main benchmarks tracked by ETFs and other passive products due to the fact that only cap-weighted indices can represent the average market performance. However, smart beta may be a complement for ETF investors if they seek a potential for outperformance of cap-weighted indices.

The first generation of alternative equity index strategies addressed the problem of concentration in market cap-weighted indices in a number of ways. Characteristics-based indices eliminated this bias by selecting stocks based on a combination of fundamental characteristics instead of market capitalisation, but these indices were simply a way of tilting the index towards stocks with low valuation ratios.

Attention has shifted towards minimum variance or strategies that overweight low-volatility stocks to improve on the risk-adjusted performance of market cap-weighted indices by lowering the risk of the portfolio. Some strategies are based on Modern Portfolio Theory and tackle the concentration problem by exploiting the phenomenon that portfolio risk is not simply the weighted average risk of its constituents. Strategies such as equal weighting or equal risk contribution evenly spread out the weight or risk of a stock in a portfolio. 

The second generation of smart beta strategies will allow investors to better control the risks to which they are exposed by clearly distinguishing between the risks associated with stock selection and weighting schemes. This second generation will also allow investors to control the level of risk relative to standard market cap-weighted indices.

The growth of smart beta is expected to increase as investors become more familiar with the first generation of strategies. Since smart beta strategies follow mechanical trading rules and can be easily replicated, asset managers are increasingly offering ETFs that use an underlying smart beta strategy. They benefit from offering these products to a broader investor base and the potential of new uses of smart beta strategies such as in tactical asset allocation or combining strategies to make performance less reliant on market conditions.