An Investor’s Guide to Smart Beta Strategies
by Feifei Li , Vitali Kalesnik and Jason Hsu
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.
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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).
Why Smart Beta?
Having experienced the Japanese bubble in the late 1980s and the dot-com bubble in the early 2000s, many investors have become acutely aware that mispricing occurs frequently in the stock market. In the presence of mispricing, a traditional capitalization-weighted index overweights overpriced stocks and underweights underpriced stocks, which leads to a suboptimal portfolio outcome. Until recently, it was assumed that active management was the only way to take advantage of market mispricing and to outperform the “market” index.
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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
I have been thinking there must be a better way. Maybe you have found it.
posted 3 months ago by Vernon Lewis from California
"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.
posted 3 months ago by John Portwood from Louisiana
I cannot read the appendix; the resolution appears too small.
posted 3 months ago by Paul Stadnik from Oregon
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
posted 3 months ago by Jean Henrich from Illinois
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.
posted 2 months ago by D.E. from New York
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.
posted 2 months ago by JW from North Carolina
