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.
In this article
Share this article
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.
To read more, please become an AAII member or CLICK HERE.
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.