Getting Smart About Beta

December 1, 2015

by Sponsored Content from Invesco

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Due to its simplicity, market-cap weighting has long been a popular means of calculating the value of market indexes. But as an investment strategy, market-cap weighting has limitations – frequently resulting in outsized proportions of overvalued stocks, and less-than-optimal exposure to undervalued stocks. Smart beta solutions seek to expand investors’ options by providing exposure to objective, rules-based methodologies that harvest returns from specific investment factors or deliver broad market exposure through alternative weighting strategies.

Invesco’s perspective on the active/passive debate

At Invesco, we believe the greatest opportunity for investors to achieve their unique objectives is through a well-constructed portfolio that spans asset classes and considers both truly active, fundamental strategies as well as systematic approaches that go beyond market-cap-weighted benchmarks.

Our Getting smart about beta white paper was generated in conjunction with Invesco’s global Investors Forum, based on research conducted by Invesco PowerShares. The Investors Forum brings together each of Invesco’s 750-plus investment professionals from around the world to discuss issues that are critical to global investors.

Key takeaways

Our research focused on 10 well-established smart beta strategies and shows that these factors and methodologies displayed a pattern of outperformance relative to the market-cap-weighted S&P 500 and MSCI EAFE indexes over multiple market cycles and in different economic climates. Our results also show that smart beta strategies generally outperformed market-cap-weighted indexes when adjusted for risk, while exhibiting lower downside capture ratios than these indexes during most market cycles.

Results vs. the S&P 500 Index:

  • All of the five factors and five alternative weighting methodologies we tested resulted in higher absolute returns relative to the S&P 500 Index during the testing period.
  • The majority of smart beta strategies resulted in higher risk-adjusted returns than the S&P 500 Index.
  • Favorable results were also seen when measuring downside capture in periods of weakness for the S&P 500 Index.

Results vs. the MSCI EAFE Index:

  • All of the factors and most of the alternative weighting methodologies we tested resulted in higher absolute returns relative to the MSCI EAFE Index during the testing period.
  • On a risk-adjusted basis, all of the factors and the majority of the alternative weighting methodologies outperformed the MSCI EAFE Index.
  • Favorable results were also seen when measuring downside capture in periods of weakness for the MSCI EAFE Index.

It is important to note that each of the factors and alternative weighting strategies we examined generated different levels of outperformance, and at different times. This has important implications for portfolio diversification, particularly given smart beta strategies’ relatively low correlation to each other. In our view, staggered performance across different periods can help lower the risk profile of a diversified portfolio. There were periods when market-cap-weighted exposure generated higher returns than a smart beta approach. Considered over the entire testing period, however, smart beta strategies generated a clear pattern of outperformance relative to the S&P 500 and MSCI EAFE indexes.

About the study

We tested five factors and five alternative weighting strategies based on the earliest date for which we could obtain reliable factor data. Our testing period for US smart beta strategies spanned December 1991 through June 2015. Our testing period for international smart beta strategies spanned June 1995 through June 2015. We also examined smart beta strategies across five full market cycles – the first of which began in July 1998. Our goal was to understand what effect these factors and weighting strategies had on performance. We examined economic variables in the form of US dollar values, interest rates and volatility. Assuming annual portfolio rebalancing, we analyzed how smart beta factors performed during these different environments.

Factors

A factor refers to an objective determinant of investment style. While broad market indexes do not filter by factors, many smart beta portfolios do. In our study, we selected five factors that are commonly used to construct smart beta portfolios. We then segmented the constituents of the market-cap-weighted S&P 500 Index and MSCI EAFE Index using these definitions:

  1. Quality – Top 20% of stocks with the highest return on equity
  2. Value – 20% of stocks with the lowest price-to-book ratio
  3. Small tilt – 20% of stocks with the smallest market capitalization within each index’s universe
  4. Momentum – Top 20% of stocks with the highest 12-month price return
  5. Low volatility – Top 20% of stocks with the lowest volatility, as measured by standard deviation, on a trailing 12-month basis

Alternative weighting methodologies

Most traditional indexes are weighted by market capitalization (the number of shares outstanding multiplied by share price), which may result in a bias toward overvalued stocks. By contrast, alternative weighting methodologies allocate stocks based on measures apart from market capitalization. In our study, we examined five commonly used weighting methodologies:

  1. Book value weighted – Weights constituent companies within an index according to their book value – the value a company would be worth if it liquidated its assets
  2. Total dividend weighted – Weights dividend-paying constituent companies within an index according to the absolute value of dividends paid by each company
  3. Equal weighted – Allocates the same weight to each constituent company within an index
  4. Low volatility weighted – Considers all stocks in an index and weights them inversely to their volatility
  5. Sales weighted – Weights constituent companies within an index according to their total revenue

In this paper, we refer to factors and alternative weighting methodologies collectively as “smart beta strategies.”

Within the study period, we examined five distinct, full market cycles, which are depicted in Figure 1. These market cycles cover peak-to-peak and trough-to-trough environments.

Smart Beta

Among US stocks, from December 1991 through June 2015, all five factors and all five alternative weighting strategies that we studied delivered excess returns relative to the market-cap-weighted S&P 500 Index, as depicted in Figure 2. Among international stocks, from June 1995 through June 2015, all five factors and four of the five alternative weighting methodologies outpaced the market-cap-weighted MSCI EAFE Index.

Smart Beta

Applying smart beta to your portfolio decisions

We believe that smart beta strategies offer a stronger investment foundation than market-cap weighting by:

  • Providing exposure to specific investment factors that may result in outperformance.
  • Helping to eliminate the shortcomings of market-cap weighting by breaking the link between a stock’s price and its weight in a portfolio through alternative weighting methodologies.

The wide variety of options may be daunting for some investors. We would urge investors to consider these three points:

Diversification. Various factors and methodologies performed differently across market and economic environments. While each strategy experienced periods of underperformance, it’s important to note that each strategy’s greatest degree and length of underperformance versus the S&P 500 and MSCI EAFE indexes occurred at different times. In addition, each strategy provided varying results across different market environments. For these reasons, we believe diversification across strategies may help mitigate the overall effect of underperformance on a portfolio.

Market cycles. Commonly, investment performance is examined on a trailing basis, such as one year, three years or five years. However, we believe full market cycles provide the proper context in which to evaluate long-term performance, as opposed to snapshots in time. This is because full market cycles capture all of the ups, downs and inflection points that affect overall performance. When considered over full market cycles, smart beta strategies have exhibited strong absolute and risk-adjusted performance.

Cost of executing

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