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Smart Beta: Too Good To Be True?

Smart Beta: Too Good to be True? via SSRN

Bruce I. Jacobs, Ph.D.

Jacobs Levy Equity Management

Kenneth N. Levy

Jacobs Levy Equity Management

February 5, 2015

The Journal of Financial Perspectives, Volume 3, Issue 2, July 2015, Forthcoming

Abstract:

Smart beta strategies promise to deliver market-beating returns with simplicity and low cost, but the reality is more complicated. Contrary to popular perception, smart beta strategies are neither passive nor well diversified. Nor can they be expected to perform consistently in all market environments. Perhaps most importantly, because of their focus on only a limited number of factors, smart beta strategies fail to exploit numerous potential profit opportunities.

Introduction

Smart beta or alternative indexing—whatever its label (we will stick with smart beta)—is a relatively new investment approach that has attracted considerable attention and investment from pension funds and individuals.1 Its popularity is hardly surprising, as smart beta promises to deliver market-beating returns in a convenient, low-cost, easy-to-understand manner.

Smart beta promoters emphasize the simplicity of the strategy’s portfolio construction and trading rules. They often compare it to passive index investing, which delivers market returns at low cost and with high transparency. Yet the goal of smart beta is the same as that of active investing—to outperform the market.

Unlike active strategies, however, smart beta eschews security research. Instead, smart beta seeks to beat the market by replacing the security weighting scheme used by passive management (capitalization weighting) with a weighting scheme that emphasizes certain security characteristics, or factors—value, size and momentum, among them—that have performed well historically.

It sounds simple enough. However, the reality of smart beta is more complicated, and its promise of higher return with lower risk is less certain. Below, we debunk some common misconceptions associated with smart beta strategies.

Smart beta portfolios are passive

Smart beta is often compared to passive investing because, like index funds, smart beta does not require the portfolio manager to forecast security returns and risks. It is essentially a rules-based approach, with preset criteria dictating the weighting of securities in the portfolio.

But a truly passive portfolio buys and holds the capitalization-weighted market; that is, the stocks are weighted according to the ratios of their market values (or capitalizations) to the total market value of all stocks in the index. It requires little trading because the portfolio and the benchmark index adjust simultaneously as security prices change.2 The result is a portfolio that delivers the underlying market’s return, along with the underlying market’s risk.

Smart beta portfolios, by contrast, weight security holdings to increase exposures to certain preselected factors. This process requires a number of decisions. Which factor should be targeted? How might the factor be defined? Should value, for example, be based on book-to-price ratio, earnings-to-price ratio, or some other criterion? How should portfolio weights be determined—by weighting stocks according to their factor exposures or by holding just those stocks with the higher factor exposures?

And unlike passive portfolios, smart beta requires periodic trading in order to rebalance the portfolio to its targeted weights as securities’ factor exposures change. How frequently should this rebalancing occur? These are all active decisions akin to the ones made by active managers every day. And like other active strategies, smart beta strategies will deliver returns that differ from those of a passive, cap-weighted index, for better or for worse [Jacobs and Levy (2014a)].

Smart beta targets the most significant return-generating factors

Smart beta equity portfolios in general target only one or a limited number of factors — value, small size, price momentum and/or low volatility. Smart beta providers would have you believe that these factors have the greatest impact on security returns. Some factors that have performed as well as or better than the chosen few are left off the smart beta menu.

In our own research, first published in 1988, we looked at 25 security characteristics, including most of the factors currently used in smart beta strategies [Jacobs and Levy (1988)]. We identified as statistically significant many more than the few factors pursued today by smart beta strategies. More recently, researchers have found dozens of factors to be significantly related to stock returns [Green et al. (2014)]. Interestingly, some popular smart beta factors, such as book-to-price, small size and price momentum, were not among the most significant. Portfolios restricted to the handful of factors targeted by smart beta are overlooking many potential opportunities.

Smart beta portfolios are well diversified

Most smart beta portfolios hold a large number of stocks, but numbers may not translate into diversification. Smart beta’s focus on a particular factor can lead to incidental bets and sector biases, which may introduce unintended risks.3 A focus on value, for example, can result in exposure to distressed firms. A focus on price momentum would have loaded up on the technology sector in 1999, prior to the tech wreck. More recently, low-volatility portfolios had a large bet against the financial sector at the market bottom in 2009, which contributed to their subsequent underperformance.

Smart Beta: Too Good To Be True?

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