Smart beta — a broad term for relatively passive investment strategies that use some alternative method of weighting stocks besides market-capitalization weights — are increasingly being considered, if not adopted, by institutional investors. They promise outperformance over traditional capitalization-weighted indexes on a risk-adjusted basis via the “factors” or other systematic “rules” they adopt in their stock selection approach.
There are some investors who still believe that following market-cap-weighted portfolios represents passive and diversified investments, unlike these systematic alternative beta approaches. These investors will be surprised by the results of our new research.
“Smart” beta is not quite appropriate as a term to cover all non-cap-weighted approaches that aim to outperform their market indexes, just as the term “hedge fund” covers very different investment strategies. Some smart beta approaches are factor-based. In other words, they use factors such as value, size and momentum to produce excess returns. But factor-based investing isn't new to quantitative equity managers who have long employed multifactor models in their portfolios. What is new is that the portfolio construction process of factor-based smart beta often reverts to simple weighting schemes without consideration of risk.
The second type of smart beta is diversification-based. It uses a systematic, rules-based approach to select equities based on some dimension of equality, such as portfolio weight, expected return, expected risk-adjusted return and risk contribution, for all stocks. We might call these approaches “naïve beta” because of their seemingly naïve assumption of equality — that all investments are the same in the dimension that is selected.
We researched four dimensions: portfolio weight; expected return; risk-adjusted return; and risk contribution. These, in turn, produced four types of naïve beta strategies: equally weighted, or EQ; minimum variance, MV; maximum diversification, MD; and risk parity, RP, respectively.