An Investor’s Guide to Smart Beta Strategies

by Feifei Li , Vitali Kalesnik and Jason Hsu

An Investor’s Guide To Smart Beta Strategies Splash image

Over the last five years, investors witnessed the emergence of a new class of equity index products known as strategy indexes, or smart betas.

Smart betas have two distinct features: First, they advocate against traditional capitalization weighting; second, they are based on relatively transparent quantitative methodologies. Whether based on empirical research or actual live history, these smart beta products do seem to offer superior performances relative to traditional indexes, substantiating the claim that cap weighting might be a suboptimal index construct. The transparency mitigates the information asymmetry problems between investors and managers, which reduces ongoing due diligence costs.

In this article, we discuss the advantages of smart betas relative to active management and traditional indexes. We also examine three of the most popular smart beta products. Additionally, in light of the increased investor interest in low-risk strategies following the 2008 financial crisis, we specifically provide an allocation framework for investors who may have different preferences for high Sharpe ratio (higher risk-adjusted return) versus high information ratio (more consistent outperformance over a benchmark such as the S&P 500 index).

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Feifei Li is a director in Research & Investment Management at Research Affiliates LLC and a visiting professor of finance at University of California, Irvine.
Vitali Kalesnik is an associate director in Research & Investment Management at Research Affiliates LLC and an adjunct professor of finance at San Diego State University.
Jason Hsu is chief investment officer at Research Affiliates LLC and an adjunct professor of finance at the UCLA Anderson Business School.


Discussion

Vernon Lewis from California posted about 1 year ago:

I have been thinking there must be a better way. Maybe you have found it.


John Portwood from Louisiana posted about 1 year ago:

"Smart Beta" indices,in my opinion, will eventually become the new benchmarks for active manager performance comparisons.I have been involved in the development and application of quantitative strategies employing smart beta concepts for many years with market-beating long-term results. But the comparable indices were capitalization weighted, in hindsight a relatively easy target using these techniques.It will not be as "easy" to beat smart beta bogeys in the future. To say that the world of active professional money management will become more competitive is an understatement.


Paul Stadnik from Oregon posted about 1 year ago:

I cannot read the appendix; the resolution appears too small.


Jean Henrich from Illinois posted about 1 year ago:

Paul, to read the appendix, click on it. This will bring up a bar that says "click here to view full image." When you click on that instruction, the appendix will open as full size in a new page. You can read it online or use your browser print command to print the page full size.--Jean from AAII


D.E. from New York posted about 1 year ago:

Perhaps a discussion of technical terms like Sharpe Ratio, Information Ratio, and Tracking Error would be useful. That could go in another Appendix.

From the article, it sounds like tracking error is a bad thing, but I can imagine it might sometimes be caused by OUTPERFORMANCE. In which case, one ought to welcome it.


JW from North Carolina posted about 1 year ago:

It is not clear to me that this study aqccounts for the expense ratio differences of the commerically available products.

A smart beta fund must overcome the drag of expense ratio and turnover costs to outperform a cap-weighted index fund's return. In a taxable account, tax inefficiency must also be overcome (but outperformance in a tax-deferred account would be good enough for many).

I look forward to more innovative research from RAFI on these and other issues.


Mike Philbrick from posted about 1 month ago:

Well written. The challenge for smart beta strategies is they still will lose large chunks of your capital in down markets. Down 47% A minimum variance portfolio vs down 55% in the cap weighted index does not "feel" different to the investor and is the precise place where so many investors make the exact wrong decision with respect to their portfolio. http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2328254


John Blevens from California posted about 1 month ago:

Very Informative article and comments as well. I have long believed the cap weighted index funds were not optimal investment strategies.


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