grad beta

Another View of Smart Beta

grad beta

As we have stated in prior articles such as this one, smart beta is primarily a marketing term that refers to the attempt to capture risk and return factors beyond beta (overall exposure to the market). The best known examples are fundamentally-weighted index funds which also include equally-weighted index funds. The problem that we see with these portfolios (aside from the trading costs in rebalancing back to fundamental or equal weights) is that to ignore the price (or market capitalization) of a company is to ignore the most current and relevant indicator of its future expected returns. As we have said on many occasions, the job of free market participants is to set prices so that investors will be compensated for the risk they bear. We have long maintained that smart beta/fundamental indexing is just another way of tilting a portfolio towards well-known compensated risk factors, and new research1 from Dimensional Fund Advisors supports our position.

A simple risk/reward comparison suggests a substantial benefit to taking the components of the S&P 500 Index and fundamentally re-weighing them based on book value, sales, cash flows, and dividends.

Reward and Risk of a Fundamental-Weighted S&P 500 Strategy
51 Years (1/1/1963 to 12/31/2013)
  Annualized Return Annualized Standard Deviation
S&P 500 Index 10.20% 14.91%
Fundamental-Weighted S&P 500 12.04% 15.07%

However, when we take a deeper look at these returns by running a multivariable regression analysis, we find that the higher return of the fundamental-weighted S&P 500 is entirely attributable to its increased tilt towards small cap and value stocks. There is zero alpha. In fact, the researchers found that the returns of the fundamental-weighted portfolio could be mostly replicated with a blend of 25% large cap blend and 75% large cap value indexes. We constructed our own 25/75 portfolio and got the identical annualized return as the fundamental-weighted portfolio but with a little higher standard deviation.

Reward and Risk of a Fundamental-Weighted S&P 500 Strategy
51 Years (1/1/1963 to 12/31/2013)
  Annualized Return Annualized Standard Deviation
Fundamental-Weighted S&P 500 12.04% 15.07%
Blend of IFA Indexes* 12.04% 15.84%

The second type of smart beta strategy analyzed by the researchers was low beta or low volatility. This is a topic we have addressed several times before such as here.  Once again, they found that the higher returns of low-volatility portfolios are attributable to the value-tilt that they have had since 1970. However, the returns data from 1928 to 1969 indicates that lower beta/volatility portfolios did not have a value tilt, and they did indeed have lower returns than higher beta/volatility portfolios. In both cases, there was no significant alpha.  

To conclude, the higher returns that we observe with smart beta strategies are attributable to exposure to compensated risk factors that we have known about for decades. If you would like to learn more about how IFA builds portfolios to capture the risk and return dimensions of the market, please call us at 888-643-3133.


1Singh, Bhanu, and Marlena Lee. “Smart Beta.”  Dimensional Research. January 2015.