Ferri: Smart Beta And Tourist Investors
Wall Street is always coming up with cunning new marketing techniques to attract tourist investors. These are less-sophisticated individual investors and advisors who are easily wowed by glitzy industry trends, only to abandon them when the strategy falls short of expectations.
The latest spin to attract tourist money is “smart beta.” The phrase didn’t exist one year ago, yet a Google search today shows 190,000 results. The inference that investing this way is smart has ignited a strong interest among less-sophisticated investors, while those who truly understand what’s behind these strategies find the phrase distasteful at best.
Beta was introduced into finance literature by Nobel Laureate William Sharpe back in the 1960s. The term denotes the risk of the stock market and it is always stated numerically at 1.0. Beta is used in portfolio management to quantify a stock portfolio’s sensitivity to market risk higher or lower than the market beta. A portfolio beta greater than 1.0 means the basket of stocks had higher risk than the market. A beta less than 1.0 means the portfolio had less market risk.
Since the introduction of market beta, cheaper computing power has made quantitative analysis of the stock market much faster and less costly. It was discovered that other broad risk factors exist in the market besides market beta, and these too have been quantified. When these risk factors are intentionally overweighted in a portfolio, it has historically outperformed the market, albeit with more total risk than the market.
These additional risks can be expressed in many ways. Some academics call them factors, and other academics call them additional betas. Some people in the industry call them alternative betas, which is not a correct term. Two of the most popular factors used in portfolio construction are the small-cap risk factor and the value-stock risk factor.
Smaller companies tend to outperform larger companies over time. This is due to additional concentrated risks such as a narrow industry focus, less distribution, higher cost of capital, less liquidity in the stock, etc. These risks are quantified and expressed as one number (or beta) and referred to in the industry as the small-cap effect.
The value-stock factor is the tendency of value stocks to outperform growth stocks over the long term. Value is differentiated from growth by sorting accounting data such as dividend yield, earnings yield and return on equity. Companies with these fundamentals tend to outperform stocks that do not have the same fundamentals. These risks can be quantified and expressed as one number (or beta), and are often referred to in the industry as the value effect.
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