How Smart Is ‘Smart Beta’?

February 19, 2013


Worldwide, investors are increasingly keen on “smart beta” investing. By this we mean passively following an index in which stock weights are not proportional to their market capitalizations, but based on some alternative weighting scheme. Well-known examples of smart beta include fundamentally weighted and minimum-volatility indexes.

In this article, we first take a critical look at the pros and cons of smart-beta investing in general. After this, we discuss in turn the most popular types of smart indexes that have been introduced in recent years. The added value of smart-beta indexes has been shown to come from systematic tilts toward classic factor premiums that are induced by their weighting schemes. We will argue that investors should be aware of the potential pitfalls of smart-beta indexes, which arise because they are not specifically designed for harvesting factor premiums in the most efficient manner, but primarily for simplicity and appeal. And although passive management can be used to replicate smart indexes, we believe it is important for investors to realize that, without exception, smart indexes themselves represent active strategies.

Smart-Beta Investing In General
The argument that is typically 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. We agree with this view, but think it is important to understand where the added value of such weighting schemes really comes from. Research has shown that the weighting schemes used by alternative indexes tend to result in structural tilts toward stocks that score high (or low) on certain factors, and that the premiums that are known to be associated with these factors are driving performance.1

For example, when compared with capitalization-weighted indexes, fundamentally weighted indexes have a systematic tilt toward value stocks. These exposures enable the strategy to benefit from the well-known value premium, which, in fact, turns out to fully explain its performance. Similarly, a minimum-volatility index captures the low-volatility premium by tilting the portfolio toward low-volatility stocks. Although this may seem obvious to some, 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 toward classic factor premiums.

We are often asked whether smart-beta investing is a form of passive investing. It is important to realize that it is not. Although passive management can be used to replicate smart indexes, smart indexes themselves are essentially active strategies. The only truly passive investment strategy is the capitalization-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 indexes 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. It is true that smart-beta indexes may bear some resemblance to true passive investing (for example, by investing in a large number of stocks with relatively low turnover), but it is important to realize that their deviations from the capitalization-weighted index, which are the key to their added value, represent active investment decisions.

In sum, so far, smart-beta investing is a way to tilt a portfolio actively toward certain factor premiums. As we are proponents of factor investing, this makes smart-beta investing a potentially promising investment approach. For example, in a recent paper, we argued that equity investors should strategically allocate a sizable part of their portfolio to the value, momentum and low-volatility factor premiums.2 Smart-beta investing represents one way in which this could be implemented in practice.

Our view on smart-beta investing can be summarized as follows: 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 indexes—namely their simplicity—is at the same time their biggest weakness. Specifically, we find that the simple tilts toward factor premiums provided by smart-beta indexes often involve significant risks that are undesirable. In addition, smart-beta strategies can be inefficient from a turnover perspective, or can have unattractive exposures to factor premiums other than the one that is primarily targeted.

Another concern with smart-beta indexes is that they are often based on backtests that only go back 10 or 15 years in time. Investors should therefore be careful to avoid chasing recent performance. To properly understand the behavior of a smart index in different environments, we recommend analyzing its performance over long historical periods, covering multiple economic cycles. Investors should also carefully think about whether the factor premiums that are driving historical smart-beta index returns are likely to persist in the future.

In the following sections, we will elaborate on these points by discussing the pros and cons of the most popular types of smart-beta indexes that have been introduced in recent years.

Find your next ETF