Smart beta strategies are hot. These index products seek to outdo traditional passive indexes by using alternative – and presumably wiser – methods of constructing their portfolios. Lately, smart beta ETFs are beating conventional index funds in performance. As smart beta is oriented to small value stocks, odds are this trend should keep going long term.
There’s no denying the popularity of the strategy. Go to any exchange-traded fund conference and the majority of presentations will be about smart beta.
This concept is an indexing methodology that is not market cap weighted, which many index funds are. In an index like the Standard & Poor’s 500, companies are weighted by the size of their market capitalizations – the total value of their outstanding shares.
A smart beta approach to the S&P 500 weighs companies differently: Some equally weight them (where Apple, which has the largest capitalization, ranks the same as Diamond Offshore Drilling, the smallest). Others use fundamental weighting, based on things like dividend rates or earnings.
It makes sense that smart beta is in vogue right now, because ETFs – the primary vehicle for this strategy – are so very popular, due to their low expenses and ease of trading. ETFs are mutual fund-like instruments, specializing in indexes and trading on exchanges like stocks.
Given the explosion in ETF offerings, if you are going to issue a new one, it has to be something different. Add in the fact that the research shows that just about any other way to weight an index beats market cap weighting over time.
The million-dollar question is why does smart beta outperform market cap weighting and will it persist? One idea why is simple: curve fitting. In other words, with computer technology, you can find a bunch of anomalies that beat the market. You need to start with a valid premise that should work, and then test it to see if it does.
For example, weighting companies by fundamental factors – meaning the companies in the best shape get a larger weight in the index and the companies in the worst shape get a lower weight – should beat a simple market cap gauge. You can then test it and see what the results are.
Here is a link to a video from Rob Arnott, head of investment manager Research Affiliates, talking about smart beta. It is a couple of years old but makes an interesting point about why such strategies likely outperform.
He took a look at a bunch of different smart beta approaches and found that they beat market cap weighting. He then took the opposite of those approaches and found that they also beat market cap weighting. On the surface, this makes no sense.
Let’s say overweighting low beta stocks (those with less volatility than the broad market) beats market cap weighting because there is something uniquely powerful about low beta stocks. Then, the inverse, overweighting high beta stocks, shouldn’t beat market cap weighting. But it does.
The answer most likely is that smart beta strategies, regardless of how they are constructed, encompass two tilts – value and size – that do better than market cap weighting. In a market cap weighted index you are always going to overweight the most expensive and therefore the largest stocks.
In most smart beta approaches you are going to favor more value and smaller stocks, this is most likely where the outperformance comes from. One study shows that from 1927 to 2014 small cap value stocks outpaced large cap growth shares by 6.2 percentage points, averaged annually.
The major factor, however, is that large caps tend to be relatively expensive, so they are more susceptible to reverting to the mean – that is, they have further to fall. To avoid that problem, my firm uses the Guggenheim Equally Weighted S&P 500 ETF (RSP) a lot in our strategies. as the name suggests, each holding has the same weighting in the portfolio, whether it be Apple or Diamond Offshore.
According to Morningstar, over the past 10 years, this ETF had an average annual return of 9.0% versus 7.9% for the S&P 500. By Morningstar’s reckoning, the average market cap of the portfolio is $21.6 billion, compared to $73.4 billion for the market cap weighted S&P 500.
So where did the outperformance come from? It could be a random anomaly that was curve fit, but most likely it is the size tilt toward smaller cap stocks.
Will smart beta outperformance persist? Who knows? Small caps did badly in 2014. Value was a laggard in the late 1990s. However, it makes sense that value – buying something for a low price – and small stock outperformance should continue over time, so any strategy that tilts toward those categories should be fine.
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Nothing in this article should be interpreted to state or imply that past results are an indication of future performance. Please consult your tax or investment advisor before making any investment decisions.
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