Smart Beta vs Cap-Weight Investing - No Longer "Whether" but "How" to Do It

The EDHEC-Risk Institute's March 2013 paper Smart Beta 2.0 contains much worthwhile info for the individual investor:

• Smart Beta index investing beats cap-weighting; (Smart Beta is an umbrella term for various alternative stock selection and weighting schemes, such as equal weighting, fundamental accounting factors or low volatility); there is little or no doubt amongst academics about the inferior efficiency - return bang for risk buck - of cap-weighting (e.g. their comments on page 5) and almost half of institutional investors have adopted an alternative index scheme. That cap-weighting isn't the best doesn't deny financial theory about an efficient market - a footnote tells us "... the efficiency of the benchmark is moreover totally independent of the existence or otherwise of an efficient market ..."with a reference to another of their papers on that point.
• Smart Beta 1.0 indices, upon which present-day ETFs are based, can be improved upon - thus the 2.0 in the paper's title. The authors state that biases and tilts with the alternative indices, which they call systematic risks of the Smart Beta indices, can be corrected and removed while still maintaining almost all of the outperformance - e.g. the small cap bias of a low volatility index can be removed by restricting stock selection to the largest cap stocks. Magic! The sector bias to utilities can be largely removed by constraints on the holdings in that sector. Maybe we cannot buy 2.0 ETFs yet but to me this presents a method for building a reasonably efficient portfolio of individual stocks e.g. pick low volatility large cap stocks while ensuring sector balance.
• Smart Beta 1.0 indices and the ETFs based on them (like some of my favorites with symbols PXC, ZLB, PRF, PDN, RSP) have in the past, and likely also will in future, despite outperforming in the long run, experience periods of 2-3 years of underperformance vs a cap-weight index. On top of that, the worst lag in performance, what they call relative drawdown, can reach 12-13% as the table below copied from the paper shows. That will certainly test an investor's confidence and resolve but proper expectations are a significant help to weathering that psychological storm. In fact, the authors recognize the "dare to be different from your peers" risk as a major obstacle for institutional investors. Fear not the EDHEC wizards propose a solution to this risk by techniques that they show can reduce the tracking error difference with the cap-weight benchmark by about half, again without eliminating the outperformance, though there is a much bigger performance hit than for the bias adjustments. 

 

• Alternative indices have different factors, which EDHEC calls specific risks, that could make them (or the ETFs based on them) not work in the future. Some indices depend on correctly estimating one or more of return, volatility or correlation to outperform, a kind of garbage-in garbage out problem (such as fundamental weighting or low volatility) while others don't estimate anything but may turn to be a very inefficient portfolio, such as equal weighting (and cap-weighting). It's a trade-off - a good model with possibly poor inputs or a crappy model requiring no inputs. Now here is what to me is a significant practical message - they find that diversifying this risk through a mix of alternative weighting schemes outperforms (in a return vs risk sense as expressed by a significantly higher Sharpe ratio) any single method. In other words, for Canadian equities we should hold a 1/3  each mix of low volatility ZLB (or TLV or XMV), fundamental-weighted PXC and equal-weighted HEW.

Business opportunity for mutual fund company - Instead of gouging ordinary investors with high fees for ineffective or fake (closet indexing) alpha outperformance, there is potential real added value for a mutual fund to offer an automated low cost Smart Beta product to Canadians (maybe we could be first with innovation as we were with ETFs in the form of TIPS). At the end of their paper EDHEC mentions that "More generally, beyond a static diversification approach, one may also implement an improved dynamic diversification approach based on making the allocation to various smart beta benchmarks conditional upon market conditions such as average correlation levels, volatility levels, etc." Jacques Lussier, in his new book Successful Investing is a Process, says the same thing. That's exactly where the leading institutional investors heading. Individual investors can do static allocation (see my suggestion here on HowToInvestOnline). But individual investors don't have the data or expertise to do dynamic allocation.

In the free-for-all that the ETF space has become, it is perhaps understandable that ETFs using index weighting schemes other than the traditional market value capitalization-weighting, such as indices based on fundamental accounting factors or low volatility, will get dismissed as mere marketing gimmicks. And there is that danger since, as the paper also points out, the alternative index construction methods and past data are not available to all to probe and test. EDHEC itself is a pretty thorough impartial prober and they show that details like the exact month chosen to rebalance or reconstitute an index can make a lot of difference to performance in any given year. If the complete index rules are not available, they say it's impossible for an investor to make an informed choice or for others to figure out if the past outperformance is likely durable or just a one-off result from cherry-picking a certain time period, for example. They show that the outperformance of fundamental weight indices is mostly, but not all, explained by the Tech bubble when it would have avoided the crazy Internet stocks. That may cause some to dismiss fundamental weight ETFs, though for me, avoiding buying into the next bubble stocks and profiting from the crash, is an attractive idea.

Thanks to Ken Kivenko for the link to the Smart Beta paper.