Equity Smart Beta and Factor Investing for Practitioners

Khalid Ghayur, Ronan G. Heaney, Stephen C. Platt

• Publisher: Wiley
• Year: 2019
• ISBN:
  9781119583448
• Edition: 1
• Topic: Negocios y empresa
• Subtopic: Acciones

A guide to the popular and fast growing investment opportunities of smart beta

Equity Smart Beta and Factor Investing for Practitioners offers a hands-on guide to the popular investment opportunities of smart beta, which is one of the fastest growing areas within the global equity asset class. This well-balanced book is written in accessible and understandable terms and contains an in-depth manual filled with analytical information and new ideas.

The authors—noted experts in the field—include a definition of smart beta investing and detail its history. They also explore the distinguishing characteristics of smart beta strategies, offer an overview of factor investing, and reveal the implementation of smart beta approaches. Comprehensive in scope, the book contains helpful examples of applications, real-life illustrative case studies, and contributions from leading and respected practitioners that explain how they approach smart beta investing. This important book:

• Contains an in-depth exploration of smart beta investing
• Includes the information written in clear and accessible language
• Presents helpful case studies, illustrative examples, and contributions from leading and respected experts
• Offers a must have resource coauthored by the Head of Goldman Sachs' equity smart beta business

Written for investors who want to tap into the opportunities that smart beta offers, Equity Smart Beta and Factor Investing for Practitioners is the comprehensive resource for learning how to create more efficient overall equity portfolios.

PART I
OVERVIEW OF EQUITY SMART BETA SPACE

Chapter 1
Evolution and Composition of the Equity Smart Beta Space

This chapter reviews the evolution of the equity smart beta space as well as some desired characteristics of smart beta offerings. This review of the evolution of smart beta investing provides useful insights in understanding the definition and current composition of the smart beta space.

Chapter Summary

• The origins of smart beta investing can potentially be traced back to research investigating the shortcomings of the capitalization-weighted market indexes. These efforts and the identified shortcomings led researchers to investigate alternative non-capitalization-weighted methodologies, such as equal-weighting, minimum variance, and fundamental weighting.
• Empirical analysis of products based on these alternative weighting methodologies depicted higher risk-adjusted returns (Sharpe ratios) compared to the market index, thereby suggesting that the capitalization-weighted market index may not be as efficient as theory (the Capital Asset Pricing Model, or CAPM) would suggest.
• These products were initially referred to as alternative equity betas in the academic literature. Today, the term “smart beta” is commonly used in reference to such strategies.
• Risk decomposition analyses of alternative equity beta strategies revealed that these strategies derive much of their market outperformance through high exposures to equity common factors, such as size, low volatility, or value, which have been well documented in the academic literature over several decades.
• As such, in our experience, investor focus shifted to capturing the equity common factors more directly and/or in a more customizable benchmark-aware implementation (an active beta perspective), which does not require replacing the capitalization-weighted market index as the policy benchmark (an alternative beta perspective).
• The composition of the smart beta space, therefore, evolved from alternative equity beta strategies to a combination of alternative beta and various factor offerings.
• The risk decomposition of alternative equity beta strategies also shows that, at least in terms of investment outcome, smart beta can be defined as mostly factor investing, as the continued success of alternative equity beta strategies critically depends on the persistence of various factor premia.
• Factor investing is not new both from a passive as well as an active implementation perspective. What is new with regard to smart beta strategies, however, is a value-adding repackaging of factor investing. Smart beta strategies create a hybrid solution that retains the attractive features of both passive and active management. Such strategies offer characteristics that emphasize efficiency, transparency, low turnover, improved diversification and capacity, and low fees.

I. Introduction

When asked about smart beta, William Sharpe’s response was that the term makes him “definitionally sick.”¹ Indeed, in the CAPM, Sharpe (1964) and others (Treynor (1961), Lintner (1965), and Mossin (1966)) provided a definition of the terms “beta” and “alpha.” Beta is the sensitivity (regression coefficient) of an asset to the capitalization-weighted market portfolio (the factor). A stock with a beta of one behaves just like the market. A stock with a beta above (below) one is more (less) risky than the market. Alpha is the return in excess of the beta-adjusted market return. Today, however, practitioners commonly use the term beta to refer to the market portfolio or some other benchmark index. That is, for practitioners beta refers to the factor itself, rather than the exposure to the factor. A beta capture typically means a passive approach, which seeks to replicate the performance of the factor or benchmark index. Returns in excess of the benchmark are referred to as “alpha,” based on the (implicit) assumption that the portfolio has a beta of one to the benchmark index.² But, what are practitioners referring to with regard to smart beta investing?

The definition and composition of the equity smart beta space is a source of confusion in the industry. Smart beta goes by many names, such as alternative beta, systematic beta, advanced beta, exotic beta, beta prime, or active beta, and many investment strategies with seemingly quite different characteristics are lumped into the smart beta category. At the outset, smart beta strategies were designed to address the potential shortcomings of capitalization-weighted market indexes and, as such, were positioned as a more efficient non-capitalization-weighted alternative. Over time, however, the term smart beta has become closely linked with factor investing. A review of the evolution of smart beta investing provides useful background and insights into the changing perspectives and the current composition of the smart beta space.

II. Evolution of Equity Smart Beta

A. Benefits of Capitalization Weighting

The CAPM (further detailed in the next chapter) demonstrates that under some simplifying assumptions the capitalization-weighted market portfolio is the most efficient portfolio on the efficient frontier, on an ex ante basis. In other words, the capitalization-weighted market portfolio is mean-variance optimal. Under the assumption of market efficiency, investors cannot do better than this portfolio. The CAPM clearly provided the theoretical motivation for the creation of capitalization-weighted equity market indexes and their widespread use in performance benchmarking and portfolio implementation. For investors, capitalization-weighted equity market indexes also offer other practical benefits, such as high capacity, high liquidity, low turnover, easy replicability, and low fees. It is no surprise, then, that capitalization-weighted equity market indexes have gained tremendous popularity with investors. Given the widespread use of such indexes around the globe, a reasonable question is whether such indexes are as efficient as theory (CAPM) would suggest. Therefore, analyzing the potential shortcomings of capitalization weighting became an important topic of research within the industry.³

B. Potential Drawbacks of Capitalization Weighting

Criticisms of capitalization weighting tend to center on three areas: concentration, volatility, and propensity to invest in expensive stocks.

At the individual stock level, concentration refers to a few companies having a large weight in the index, which exposes investors to significant stock-specific risk.⁴ In many countries, in fact, just a handful of names may account for a large proportion of the weight of the market index. At the end of 2017, as an example, the three largest Belgian companies trading on Euronext Brussels had an aggregate market capitalization larger than that of the remaining 130 companies combined. Capitalization-weighted market indexes can also become heavily concentrated in individual industries/sectors (e.g. the technology sector in the S&P 500 Index during the technology bubble) or even countries (e.g. Japan in the MSCI EAFE Index in the mid- to late 1980s).

Another potential drawback of capitalization weighting is that it may expose passive investors to high levels of volatility. Higher volatility may be caused by the noisy nature of market prices as well as the interaction between the speculative behavior of investors and concentration. For instance, overenthusiasm of investors may lead to overpricing in individual stocks and/or industries. Rising prices for these stocks and/or industries increases their capitalization and weights in the market index, thus causing concentration. Concentration, in turn, may force passive investors, who closely replicate the market indexes, to hold more of the overpriced stocks and/or industries. As mispricing eventually corrects, investors experience significant volatility and suffer significant losses by virtue of being overly concentrated in the most overpriced stocks and/or industries of the market. The formation of bubbles, and their subsequent bursting, may imply that investors replicating the capitalization-weighted market indexes end up taking more risk than would otherwise be needed to capture the equity risk premium. One well-known example of such dynamics is the price-to-earnings (PE) ratio as well as the weight of technology stocks in the S&P 500 Index during the technology bubble. Between 1998 and 2000, as the overenthusiasm of investors led to the doubling of valuation ratios for technology stocks, their weight in the S&P 500 Index increased from 13% in 1998 to more than 30% at the start of 2000. As the technology bubble burst, the valuations and weight of technology stocks shrunk considerably, causing passive investors to experience significant portfolio volatility and losses.

Arnott et al. (2005) identified the performance drag as another potential drawback of capitalization-weighted market portfolios. Under the assumption that market prices tend to revert to underlying fundamental values, capitalization weighting tends to overweight overvalued stocks and underweight undervalued stocks, thus introducing a potential performance drag as the mispricing inevitably corrects. The performance drag may be another reason why the capitalization-weighted market portfolio may not be optimal.

C. Suggested Solutions

To address the concentration issue, weighting schemes that provide more diversification were explored. These efforts led to the development of equal-weighted indexes, capped indexes (which limit the weight of individual stocks at a certain level, such as 5% or 10%), diversity indexes (e.g. Fernholz (1998)) and maximum diversification indexes (e.g. Choueifaty and Coignard (2008)). Empirically, these portfolios were shown to outperform capitalization-weighted market indexes, on a risk-adjusted basis, thereby suggesting that concentration risk is not rewarded over time and makes capitalization-weighted indexes less efficient than those employing weighting schemes that realize more diversification. In relation to the higher volatility of capitalization-weighted market portfolios, Haugen and Baker (1991) investigated the characteristics of the ...