The investment thesis for many alternative beta strategies seems unrelated to their simulated value added.
A growing variety of alternative beta strategies have come to market in recent years. Many of these strategies are purported to be “Smart Betas.” Are they? What makes them smart?
According to Towers Watson (2013), a leading global investment-consulting firm, “Smart beta is simply about trying to identify good investment ideas that can be structured better... smart beta strategies should be simple, low cost, transparent and systematic.” This straightforward definition indicates what investors ought to expect of a “Smart Beta.” Our research suggests that many alternative beta strategies fall short of this definition. Some are overly complex and opaque in the source of their value added. Others will incur unnecessary implementation costs. Many alternative beta strategies don’t seem so smart.
Sources of Value Added
A growing body of research shows that non-price-weighted strategies add value over their capitalization-weighted benchmarks.1 The results show surprisingly consistent simulated value added for the most popular alternative beta strategies.
In an article published in the Journal of Portfolio Management (JPM), Arnott, Hsu, Kalesnik, and Tindall (2013) extend the research to a set of “sensible investment beliefs.” The authors demonstrate that sensible investment beliefs, when translated into portfolio-weighting strategies, result in outperformance against the cap-weighted benchmark index—and so do the arguably nonsensical inverses2 of those weighting strategies! The authors go on to show that even random weighting, as by Malkiel’s monkey,3 consistently outperforms a cap-weighted index.
How can seemingly sensible weighting strategies, the inverses of those strategies, and Malkiel’s monkey throwing darts all consistently add value? The authors observe that all of these strategies involve rebalancing the securities in the portfolio to target weights calculated without reference to market prices. This rebalancing involves a “contra-trade against the market’s price changes at each rebalancing,” which “necessarily results in value and size tilts, regardless of the weighting method chosen.”
Arnott et al. (2013) conclude that value and size factor exposures arise naturally in non-price-weighted strategies and constitute the main source of their return advantage. Revealingly, the authors find “that the investment beliefs upon which many investment strategies are ostensibly based play little or no role in their outperformance…. This does not mean that these strategies’ outperformance is suspect. Rather, as it turns out, these investment beliefs work because they introduce, often unintentionally, value and small cap tilts into the portfolio.” With these results in mind, some alternative beta strategies appear to fail the first part of the objective: efficient capture of a sound investment idea. These strategies add value, like Malkiel’s monkey, simply because they rebalance to non-price weights.