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Getting Smart About Beta

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Getting Smart About Beta

December 1, 2015

by Sponsored Content from Invesco


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.


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.

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 smart beta strategies. While smart beta strategies can be accessed through a variety of investment vehicles, including mutual funds, ETFs are the primary vehicles through which smart beta strategies are implemented. ETFs are designed to track underlying financial indexes, and there are costs involved with the tracking process. Our analysis did not include implementation or management costs. Had these costs been included, results may have varied. Though results may have varied, we do not believe the inclusion of these costs would have materially affected the results. (See notes for more information.)


The results of our study show that smart beta strategies displayed a clear pattern of outperformance relative to the market-cap-weighted S&P 500 and MSCI EAFE indexes over two decades – a period that included five different market cycles and other forms of market uncertainty.

While conventional wisdom dictates that higher returns generally come with added risk, the majority of the smart beta strategies we studied outperformed their market-cap-weighted benchmark, even when adjusted for risk. This is meaningful for investors who use smart beta strategies in their core portfolios with the goal of generating excess returns.

Investors should take into account their own considerations before investing in any strategy. We encourage investors to talk to their financial advisors about their ideal exposure to any single methodology and to discuss the optimal way to combine various factors in order to pursue their objectives across market cycles.


Implementation and management costs. Our analysis did not include implementation costs or management fees; however, we do not believe these would have materially affected results. The smart beta strategies tested exhibited excess returns of 2.7% on average, while we estimate these costs to be 50 basis points (.50%) or less for most ETFs. The costs to implement smart beta strategies vary by structure, methodology and provider. To determine the average fees and implementation costs for smart beta strategies, we considered ETFs categorized by Morningstar as “strategic beta” – strategic beta is another common term used for smart beta strategies. We compared the five-year annualized returns for each ETF relative to its underlying index. The difference between these returns provides a proxy for the costs associated with implementation and management of smart beta strategies. On average, ETFs in this category trailed their underlying index by 33 basis points (.33%), with two-thirds of the ETFs lagging their underlying index by less than 50 basis points (.50%).

Important Information

There are risks involved with investing in ETFs, including possible loss of money. Shares are not actively managed and are subject to risks similar to those of stocks, including those regarding short selling and margin maintenance requirements. Ordinary brokerage commissions apply. The Fund’s return may not match the return of the Underlying Index.

The risks of investing in securities of foreign issuers can include fluctuations in foreign currencies, political and economic instability, and foreign taxation issues.

Stocks of small and mid-sized companies tend to be more vulnerable to adverse developments and may be more volatile than larger, more established companies. Investments in real estate related instruments may be affected by economic, legal, or environmental factors.

Foreign securities risk. Foreign investments may be affected by changes in a foreign country’s exchange rates, political and social instability, changes in economic or taxation policies, difficulties when enforcing obligations, decreased liquidity, and increased volatility. Foreign companies may be subject to less regulation resulting in less publicly available information about the companies.

Market risk. The prices of and the income generated by the fund’s securities may decline in response to, among other things, investor sentiment, general economic and market conditions, regional or global instability, and currency and interest rate fluctuations.

Small- and mid-capitalization risks. Stocks of small- and mid-sized companies tend to be more vulnerable to adverse developments and may have little or no operating history or track record of success, and limited product lines, markets, management and financial resources. The securities of small- and mid-sized companies may be more volatile due to less market interest and less publicly available information about the issuer. They also may be illiquid or restricted as to resale, or may trade less frequently and in smaller volumes, all of which may cause difficulty when establishing or closing a position at a desirable price.

The MSCI EAFE Index is an unmanaged index considered representative of stocks of Europe, Australasia and the Far East.

The S&P 500® Index is an unmanaged index considered representative of the US stock market.

Beta is a measure of risk representing how a security is expected to respond to general market movements. For example, a beta of one means that the security is expected to move with the market. A beta of less than one means the security is expected to be less volatile than the overall market. Betas greater than one are expected to exhibit more volatility or movement than the general market.

Book value is a company’s total assets minus liabilities and intangible assets.

Return on equity is a measure of profitability that shows how much profit a company has generated using shareholders’ invested capital.

Smart beta is an alternative and selection index based methodology that seeks to outperform a benchmark or reduce portfolio risk, or both.

Standard deviation is a measure of the dispersion of a set of data from its mean. The more spread apart the data, the higher the deviation.

Volatility is the amount of fluctuation in the price of a security or portfolio over time, as measured by standard deviation.

Diversification does not guarantee a profit or eliminate the risk of loss.

The information provided is for educational purposes only and does not constitute a recommendation of the suitability of any investment strategy for a particular investor. Invesco does not provide tax advice. The tax information contained herein is general and is not exhaustive by nature. Federal and state tax laws are complex and constantly changing. Investors should always consult their own legal or tax professional for information concerning their individual situation. The opinions expressed are those of the authors, are based on current market conditions and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals.

Smart Beta

All data provided by Invesco unless otherwise noted.

Invesco Distributors, Inc. is the US distributor for Invesco Ltd.’s retail products and collective trust funds. Invesco Advisers, Inc. and other affiliated investment advisers mentioned provide investment advisory services and do not sell securities. Invesco Unit Investment Trusts are distributed by the sponsor, Invesco Capital Markets, Inc., and broker-dealers including Invesco Distributors, Inc. PowerShares® is a registered trademark of Invesco PowerShares Capital Management LLC (Invesco PowerShares). Each entity is an indirect, wholly owned subsidiary of Invesco Ltd.

©2015 Invesco Ltd. All rights reserved.

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