{"id":38539,"date":"2014-12-02T07:04:03","date_gmt":"2014-12-02T06:04:03","guid":{"rendered":"http:\/\/beta.next-finance.net\/opinion\/shiny-new-name-or-genuinely-new-idea\/"},"modified":"2019-12-30T23:13:40","modified_gmt":"2019-12-30T22:13:40","slug":"shiny-new-name-or-genuinely-new-idea","status":"publish","type":"post","link":"http:\/\/beta.next-finance.net\/en\/opinion\/shiny-new-name-or-genuinely-new-idea\/","title":{"rendered":"Shiny New Name or Genuinely New Idea?"},"content":{"rendered":"

It is a new, modern-sounding name, and carries with it the positive
\nconnotations of \u2018smart\u2019 technology currently popular in consumer electronics.
\nWho would admit to not having a smartphone or aspiring to a smart TV? The
\nmarketing implication of the term is that products labeled \u2018smart\u2019 seem to do
\nwhat the users require of them almost intuitively, and without the requirement
\nfor skilled operation.
\n
So it is certainly a new, 21st century name \u2013 but is it really a new idea?
\n
In short, the answer is clearly \u2018no\u2019 \u2013 systematic alternatives to weighting
\nschemes based on market capitalisation have, in fact, been around for more
\nthan thirty years. <\/strong> <\/em> <\/p>\n

Dumb Beta?<\/h2>\n

Of course, the unspoken implication of the term \u2018Smart Beta\u2019
\nis that good old-fashioned traditional beta is not so smart. The
\noriginal idea of a market\u2019s \u2018beta\u2019 has been around since the
\n1960s. Over the years, it has become industry shorthand for
\nexposure to the market as measured by a capitalisationweighted
\nportfolio. Such portfolios, despite the fact that they
\nrepresent just one of many possible systematic ways of
\nweighting stocks in a portfolio, have themselves become the
\naccepted proxy for the return of the market as a whole. They
\nhave the advantage of low cost, utter simplicity and limitless
\ncapacity. As a cheap, quick and easy way of investing vast
\nsums in the stock market, cap-weighted index portfolios have
\nattracted trillions of dollars from investors all over the world.<\/p>\n

Academic fuel to the cap-weighting fire was provided from the
\nvery beginning by the Capital Asset Pricing Model, which
\nargues that (as long as you accept a whole range of oversimplifying
\nand unrealistic assumptions) the cap-weighted
\nindex is, in fact, an efficient portfolio. This cornerstone of
\nModern Portfolio Theory spawned the belief, still widely held by
\nmany, that the cap-weighted index portfolio offers the highest
\nachievable return for the level of risk associated with it. Capweighted
\nindex funds continue to attract large volumes of
\nasset flows from all types of investors, all over the world, who
\nstill cling to this long-discredited notion.<\/p>\n

\"intech-exhibit_1-cap-weighted_index_assets.jpg\"<\/p>\n

When did the first \u2018Smart Beta\u2019 ideas emerge?<\/h2>\n

Although the term \u2018Smart Beta\u2019 was 30 years from being
\ncoined, systematic investment strategies designed to improve upon the inherent flaws of cap-weighted index portfolios began
\nto emerge already in the 1980s. For example, Dr. E. Robert
\nFernholz, founder of INTECH and a creator of enhanced equity
\nportfolio construction methods, published a seminal paper as
\nearly as 1982 in which he demonstrated that not only is the
\ncap-weighted index NOT an efficient portfolio, but that a higher
\nreturn can be generated with similar risk by simply better
\ndiversifying the holdings and rebalancing. At INTECH, we have
\nbeen pursuing such an investment strategy for over 25 years,
\nand today manage in excess of $40 billion according to such
\nprinciples.<\/p>\n

Subsequent further attempts by practitioners and academics
\nin the investment management industry to identify their own
\npersistently successful portfolio \u2018tilts\u2019 are well-documented.
\nThere has been a plethora of various alternative weighting
\nschemes proposed over the years: equal-weighted, revenue-weighted,
\ndividend-weighted, earnings-weighted, liquidity-weighted,
\nbeta-weighted, wealth-weighted and GDP-weighted,
\nto name but a few. Various blends of these \u2018factors\u2019 and
\nothers formed the basis for a succession of competing
\n\u2018Enhanced Indexation\u2019 products offered by quantitative
\nmanagers throughout the 1990s and beyond. They, too, may
\nhave been thrown into the \u2018Smart Beta\u2019 bucket at the time had
\nthe term been available. <\/p>\n

However, a small number of these individual \u2018factors\u2019 stand
\nout from the crowd; they are \u2018Size\u2019 (1981), \u2018Value\u2019 (1992) and
\n\u2018Momentum\u2019 (1997). They have attracted such a following over
\nthe last three decades that they have achieved celebrity status
\nand become named \u2018effects.\u2019 Some might add to this list
\n\u2018Volatility,\u2019 with the \u2018Low Volatility Anomaly\u2019 currently knocking
\non the door of the \u201cRisk Factor Hall of Fame.\u201d Portfolios
\nconstructed according to these measures have become
\nimmortalised as winning investment strategies that just \u2018work.\u2019
\nWhether or not this is true is open to doubt and the subject of
\na later paper. However, suffice it to say, that investment
\nmanagement firms have built entire businesses and manage
\nhundreds of billions of dollars based upon offering products
\ndesigned to exploit these effects. And furthermore, along with
\nbeta, they have become enshrined in both the literature,
\npractice and faith system of our industry as the basic
\ncomponents of portfolio performance: risk factors that can be
\nused to explain the performance of other portfolios. <\/p>\n

Smart Beta \u2013 a Name in Search of a Category?<\/h2>\n

So why the sudden emergence of \u2018Smart Beta\u2019 as a category, if
\nthe constituents of that category have been around for over 30 years? The answer lies most likely in some investment
\nindustry themes that have risen to heightened prominence in
\nthe last five years: how to achieve better returns, how to
\nreduce risk and how to control costs.<\/p>\n

Two major stock market crashes since the turn of the century
\nhave left investors bruised, pension funds in deficit and
\neveryone in need of more return. At the same time, there has
\nbeen a heightened focus by plan sponsors, regulators and
\ninvestment committees on risk \u2013 how to diversify exposure,
\nand thereby reduce it. And achieving both of these things in a
\nhighly cost-effective way is at the forefront of investors\u2019 minds
\nat a time of global economic austerity and modest expected
\nfuture returns from the capital markets as a whole. The
\nconcept of \u2018Smart Beta\u2019 has been pushed forward to meet
\nthese challenges.<\/p>\n

As previously noted, the term \u2018beta\u2019 is synonymous with
\npassive management, of which a key benefit is its very low
\ncost. However, for about 50 years, the only passive option on
\nthe menu was cap-weighted indexation, which, though
\ninexpensive, has a number of shortcomings. Chief amongst
\nthese are: overexposure to overvalued stocks, overexposure
\nto large stocks and lack of downside protection. Even in an
\nindex fund there\u2019s a reasonable chance you might lose half
\nyour money in a 12-month period.<\/p>\n

\u2018Smart Beta\u2019 approaches purport to offer the same low-cost,
\npassive approach enjoyed by cap-weighted index portfolios,
\nbut designed to exploit many of the favourite risk factors
\nhighlighted above, to generate a higher return at the same or
\nless risk. They are sometimes called \u2018alternative\u2019 index
\nportfolios, as they employ weighting schemes based on
\nmeasures other than market capitalisation, such as
\nfundamental valuation metrics or stock volatility. So accepted
\nand mainstream have these \u2018effects\u2019 now become that they
\nare considered commoditised exposures that can be
\naccessed mechanistically and passively through rules-based
\nprocesses as part of one\u2019s \u2018Smart Beta\u2019 allocation \u2013 a
\ndiversifying alternative to traditional cap-weighted portfolios.
\nAlthough such factor-based strategies have been around for
\nover 30 years, \u2018Smart Beta\u2019 index portfolios aim to remove
\nthe need to employ skilled active managers to access them.
\nWhat was previously sold as alpha has been re-packaged as
\nbeta and offered to investors in generic \u2018index\u2019 form. <\/p>\n

But are these strategies really indices? And are they truly
\npassive? Is \u2018Smart Beta\u2019 genuinely smart, and is it really
\nbeta? The answers to these questions and others are the
\ntopic of the second article in this series.