Exploring Smart Beta

Exploring Smart Beta

Exploring Smart Beta by Jason Hsu, Research Affiliates

Exploring Smart Beta – Introduction

Smart beta strategies are increasingly recognized as a key element in investors’ portfolios. Nearly $360 billion is already invested in U.S. exchange-traded products tracking what Morningstar calls “strategic beta” indices,1 and industry observers expect to see continuing growth in assets under management.

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In this environment, many investors want to learn more about smart beta investing—what it means, how it differs from traditional active and passive management, and why it merits an allocation in their portfolios.

In late 2013 and early 2014, Jason Hsu, Ph.D., wrote a series of short essays about selected topics in smart beta investing, ranging from how it differs from traditional capitalization-weighted indexing to the dollar cost averaging that naturally results from periodic rebalancing. These concise pieces provide a solid introduction to important dimensions of smart beta strategies.

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Research Affiliates is pleased to make the content of Dr. Hsu’s series of articles accessible in a new format that makes it easy for investors to understand key features of smart beta indexing. Because we are always engaged in research, the online version of this tutorial contains many in-context hyperlinks to other Research Affiliates publications.

Readers who wish to explore selected topics in greater depth will find these links helpful. We hope the insights you gain from the ideas and research findings presented here will help you refine your own thinking about smart beta investing. The full range of writings by our firm’s investment professionals—addressing macro-economic issues, asset allocation, and target-date funds, among many other topics—is publicly available on our website.


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The Genesis Of Smart Beta Investing

Smart beta strategies are a radical departure, but they didn’t suddenly appear from nowhere. They are rooted in the history of financial theory and the evolution of index investing. A glance back at the origins is a first step toward understanding how smart beta strategies have redefined the choices available to investors.

How Does Traditional Index Investing Work?

Conventional capital market indices are:

  • Capitalization-weighted
    • With cap weighting, a company’s share of the index depends in part on the price of its common stock
    • If the market price of a stock rises, so does its weight as a percent of the total index, and vice versa
  • Based on the Capital Asset Pricing Model (CAPM)
    • All investors are exposed to market risk
    • If the market rises, individual stocks will rise to some extent, and vice versa
    • Market beta is an estimate of how much a particular stock will rise or fall for a given rise or fall in the overall market

BUT over the past 40 years the CAPM has been rejected on both theoretical and empirical grounds.

Many well known indices assign weights to stocks on the basis of the issuing companies’ market capitalization—the price of the stock multiplied by the number of shares outstanding—as a percentage of the total market capitalization of all the stocks in the index.

For example, as of June 30, 2014, General Electric Company was 1.5% of the S&5 500 Index.

General Electric’s weight in the index depends partially upon the market price of its common stock. If the price rose to $30 per share, the index allocation to General Electric would rise to 1.7%; if the price fell to $20, General Electric’s weight in the index would drop to 1.2%.

What Makes Smart Beta Different?

The state of the art in return modeling is the multi-factor framework based on the Arbitrage Pricing Model (APT).

  • There are multiple sources of equity return premia
    • Some premium returns compensate investors for taking risk
    • Some can be gained by taking advantage of other investors’ patterns of behavior
  • The equity premium sources that appear to be most robust over time and across countries are associated with these factors:
    • Market
    • Value
    • Momentum
    • Low Volatility

For more information, see “Smart Beta: The Second Generation of Index Investing” and “The Promise of Smart Beta.”

The Factor Zoo

Academic researchers have claimed to find many other risk factors that generate return premia. We find, however, that these are the only ones that matter: market beta, of course, and the value, momentum, and low volatility effects.

For more information, see “Finding Smart Beta in the Factor Zoo.”

Smart beta is an evolutionary advance in beta investment strategy just as multi-factor APT is an improvement in financial theory.

An Update On The Size Effect

In the early 1990s, Eugene Fama and Kenneth French developed a hugely influential return model with three factors: market, value, and size. The size factor reflected a finding that, on average, small-cap stocks generated higher returns than large-cap stocks. In other words, there was a small-cap premium. However, the small-cap anomaly has not been observed in the United States since the 1980s and does not exist outside the U.S. dataset. For more information, see “Busting the Myth About Size.”

Traditional passive investing offers exposure to a single source of return-market beta. Smart beta strategies access multiple equity return sources, especially the value and low volatility factors.

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