Investors are increasingly interested in “smart beta” investing, an investment strategy base on following an index in which stock weights are not proportional to their market capitalizations, but based on some alternative weighting scheme.
Smart beta strategies vary, but they have one thing in common: Size doesn’t matter.
Examples include fundamentally-weighted indices and minimum-volatility indices.
Some smart beta funds weight the portfolio according to fundamentals like earnings, dividends and cash flow; others weight it to low volatility or upward price momentum.
The simplest and oldest smart beta strategy is equal-dollar weighting: investing the same amount of money in every company in an index, large or small.
The idea of smart beta is that it maintains the passive approach of a mainstream index fund, but tweaks it so that it outperforms this high-profile benchmark.
For example, the PowerShares FTSE RAFI U.S. 1000 invests in a fundamentally weighted index of the largest U.S. companies selected on the fundamental measures of book value, cash flow, sales and dividends. The 1,000 equities with the highest fundamental strength are weighted by their fundamental scores.
But are smart beta funds really so smart?
According to David Blitz, Head of Robeco Quantitative Equity Research, typical argument used to motivate smart beta investing is that the capitalization-weighted index is inefficient, and that a more efficient portfolio can be constructed by applying some alternative stock weighting scheme.
The performance of fundamental indices can be explained by the fact that these indices systematically tilt towards value stocks, and these exposures enable the strategy to benefit from the well-known value premium.
“Many smart beta index providers are still reluctant to acknowledge that their performance is driven by factor exposures, and that their weighting schemes are merely a novel way of establishing exposures towards classic factor premiums”, Blitz says.
Smart beta investing is not a form of passive investing. According to Blitz, passive management can be used to replicate smart indices, but smart indices themselves are essentially active strategies.
Smart beta indices require various subjective assumptions and choices. For example, they require periodic rebalancing to maintain their profile.