Smart Beta
Using relatively passive-rule based strategies to gain greater than market returns without assuming more risk than investing in a low-cost total stock market index fund.
The Sharpe Ratio: (excess return over the risk-free rate) / (risk of the strategy). The risk-free rate is usually the return from a 3-month treasury bill. Higher Sharpe Ratios are better.
Smart beta argues that pure indexing (weighting by market cap) is not optimal. The portfolio should be tilted in some direction.
Four Tasty Flavors: Pros and Cons
Value Wins
Dodd and Graham argued that value wins over time. Stocks with low P/E and low P/B (B = book value) are high value stocks. Note that future growth projections are not used.
But also note that companies in financial distress usually sell at low P/E and P/B, e.g. Citigroup and BoA in 2009 when people thought they’d get nationalized, wiping out equity.
Smaller Is Better
Small-company stocks tend to generate larger returns than large-company stocks. Recall that they’re more risky.
Sometimes the stocks may have some illiquidity, so it’s not always a slam dunk.
Short-Term Momentum Exists
Individuals tend to flock to stocks that are rising.
Investors don’t adjust their expectations immediately after news reports.
Low-Beta Stocks Return as Much as High-Beta Stocks
The low \( \beta \) stocks can improve the investor’s risk-return tradeoff.
What Could Go Wrong in a Smart Beta Portfolio?
Rebalancing can involve considerable transactions costs.
If the factor returns are caused be behavioral errors rather than risk, the strategy will be self-defeating as more investments flow into smart-beta products.
Smart beta with single-factor products has underperformed.
Blended Factor Strategies
If correlation between factors is small or negative, factor diversification helps.
Dimensional Fund Advisors (DFA, $500b AUM in 2018) use size and value factors from Fama-French, and tilt toward recent price momentum and profitability growth. Advisers are unconflicted - they don’t collect extra fees for placing investors in particular funds. However, they charge advisory fees, e.g. 1%.
Research Affiliates Fundamental Index (RAFI, $200b AUM) claim pure indexing has too many overpriced growth stocks. They use economic footprints (e.g. earnings and assets) to weight stocks. RAFI performed well post 2009 because large-bank stocks were low compared to book value.
Goldman Sachs Active Beta ETF uses good value, strong momentum, high quality, and low volatility.
Equally-Weighted Portfolios
Their diversification and risk characteristics differ from those of capitalization-weighted portfolios.
They are also tax inefficient, as rebalancing involves selling stocks that have risen the most in price.
Implications for Investors
Smart Beta portfolios provide factor tilts at lower expense ratios than those charged by traditional active managers.
Many single factor ETFs have failed to produce reliable excess returns. Moreover, rebalancing makes these funds less tax efficient than capitalization weighted funds.
Multifactor “smart beta” funds take advantage of the low or negative correlations between the factors. They could supplement a broad-based core index portfolio.
Smart beta portfolios are more of marketing hype than smarter investing. They may be self-defeating as “value” and “small size” become richly priced.
The Risk-Parity Technique
Tilt towards relatively safe assets with modest returns and low volatility. Leverage up this safe portfolio to increase risk and return.
People tend to overpay for moonshot stocks. Very safe securities appear to offer higher returns than their risk level commands.
| Security | Average Annual Return, 2007 - 2016 (%) | Standard Deviation, 2007 - 2016 (%) |
|---|---|---|
| S&P 500 | 8.6 | 2.0 |
| 10-Year U.S. Treasury Bond | 5.1 | 0.8 |
| Leveraged Bond Investment (50% margin) | 10.2 | 1.6 |
Many institutional portfolios contain 60 percent stocks and 40 percent bonds. A risk-parity portfolio increases the bonds (or fixed-income) portion.
Building a Risk-Parity Portfolio
Risk-parity portfolios typically include real estate assets, commodity funds, treasury inflation-protected securities, etc.
As long as the added asset class has a relatively low correlation, the addition lowers the volatility of the overall portfolio.
Note that there’s no active portfolio management, just adjusting such that all components contribute equally to portfolio risk.
What Could Go Wrong in an RP Portfolio?
A levered investor may be forced to liquidate his position during a sharp downturn in prices, turning a temporary loss into a permanent one.
The other asset classes may fail to produce adequate risk premiums or deviate from their expected correlation.