Investors are embracing “smart-beta” investing, passively following an index in which stock weights are not proportional to their market capitalisations but based on an alternative weighting scheme. Examples include fundamentally weighted indices and minimum volatility indices.
In the enclosed white paper, below, we first take a critical look at the pros and cons of smart-beta investing in general. After this we discuss the most popular types of smart indices that have been introduced in recent years.
Recently introduced smart-beta indices claim it is possible to improve on a traditional capitalisation-weighted index by using some alternative weighting formula
The source of the added-value of smart-beta indices is systematic tilts towards classic factor premiums, which are induced by these weighting schemes
Investors should be aware of the pitfalls associated with smart-beta indices, which arise because smart indices are not specifically designed for harvesting factor premiums in the most efficient manner, but primarily for simplicity and appeal.
Although passive management can be used to replicate smart indices, investors should realise that, without exception, smart indices themselves represent active strategies.
Smart beta, essentially active
We are often asked whether smart-beta investing is a form of passive investing. It is important to realise it is not. Although passive management can be used to replicate smart indices, smart indices themselves are essentially active strategies.
The only truly passive investment strategy is the capitalisation-weighted broad market portfolio, which represents the only buy-and-hold portfolio that could, in principle, be held in equilibrium by every investor.
Smart-beta indices are fundamentally different, because they require various subjective assumptions and choices. Their active nature is also illustrated by the fact that they require periodic rebalancing to maintain their profile.
Smart beta in relation to factor premiums
We think it is important to understand where the added-value of smart-beta as alternative weighting schemes really comes from.
Research has shown that the weighting schemes tend to result in structural tilts towards stocks which score high (or low) on certain factors, and that the premiums which are known to be associated with these factors are driving performance*.
For example, compared with the capitalisation-weighted index, fundamental indices systematically tilt towards value stocks. These exposures enable the strategy to benefit from the well-known value premium, which, in fact, turns out to explain its performance fully.
*See, for example, Chow, Hsu, Kalesnik & Little (2011), A Survey of Alternative Equity Index Strategies, Financial Analysts’ Journal, Vol. 67, No. 5, pp. 37-57.
But is smart-beta investing really smart?
Although smart-beta investing may be a good start, we believe investors can do better. The reason is that the main appeal of smart-beta indices, namely their simplicity, is at the same time their biggest weakness. Specifically, we find that the simple tilts towards factor premiums provided by smart-beta indices often involve significant risks that are undesirable.
In this white paper we elaborate on these points by discussing the pros and cons of the most popular types of smart-beta indices that have been introduced in recent years.
For the complete white paper, click here.
For more information on Robeco quant research and solutions, click here.
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