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Written by: Yazann Romahi , Chief Investment Officer, Quantitative Beta Strategies
The investment industry is abuzz with talk of smart beta, and many are touting it as a revolution in passive investing. In reality, it is simply the latest iteration in an evolution of a 100-year-old concept. It offers, in essence, an improvement on the first and most important property of an investment portfolio: diversification.
The concept of the average market return existed as early as the 19th century when the Dow Jones Industrial Average was created. Prior to the development of investible indexes, investors attributed 100% of a fund’s return to manager skill (“alpha,” as it would later come to be known). “Beta” embodies the idea that investors could earn a positive return, or equity risk premium, simply for holding a large number of risky securities — “the market” in other words. The concept was still alien to the investment community when John C. Bogle launched the Vanguard 500 Index Fund in 1975. With time, it became clear that a significant portion of return was driven by exposure to the equity risk premium.
Escaping the mega cap trap
Market cap weighted indexes have dominated indexation since the introduction of the concept of beta. The performance of indexes of this kind is heavily dependent on the performance of the largest stocks, as shown in the chart below. An attempt to avoid concentration in mega-caps led to the next innovation in index investing: smart beta. By systematically seeking to maximize diversification, smart beta broke the link between index weights and market capitalization. A further innovation looked to explicitly embed factors other than raw equity beta, such as low volatility or value.
Smarter beta, wiser portfolios
While the current smart beta discussion is largely framed around these factor exposures, there are actually two distinct components of index design. How factor exposures are dealt with is important – but equally important is the approach to portfolio construction. Both components should focus on maximizing diversification because that is how they add value. The next generation of indexes taps into diversification along both of these dimensions.
Diversifying risk factors—by gaining exposure to indexes of low volatility or under-valued stocks, say, as well as broad equity— may help insulate investors from the potential failure of any one investment philosophy. And ensuring diversification along country, sector and stock lines may help protect investors from unanticipated idiosyncratic events.
Investment implication
As our understanding of what drives equity returns has evolved, the portion of returns we attribute to alpha has diminished, and the number of beta factors has grown—along with the returns we can attribute to them. This raises the bar for the active investor by pinpointing manager alpha more precisely. For the passive investor, it provides ever more diversification through systematic and affordable access to compensated equity risks.
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