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For example, in a recent paper, we argued that equity
investors should strategically allocate a sizable part of their
portfolio to the value, momentum and low-volatility factor
premiums. 2 Smart-beta investing represents one way in
which this could be implemented in practice.
Our view on smart-beta investing can be summarized as
follows: Although smart-beta investing may be a good start,
we believe investors can do better. The reason is that the
main appeal of smart-beta indexes—namely their simplicity—is
at the same time their biggest weakness. Specifically,
we find that the simple tilts toward factor premiums provided
by smart-beta indexes often involve significant risks
that are undesirable. In addition, smart-beta strategies
can be inefficient from a turnover perspective, or can have
unattractive exposures to factor premiums other than the
one that is primarily targeted.
Another concern with smart-beta indexes is that they
are often based on backtests that only go back 10 or 15
years in time. Investors should therefore be careful to avoid
chasing recent performance. To properly understand the
behavior of a smart index in different environments, we
recommend analyzing its performance over long historical
periods, covering multiple economic cycles. Investors
should also carefully think about whether the factor premiums
that are driving historical smart-beta index returns are
likely to persist in the future.
In the following sections, we will elaborate on these points
by discussing the pros and cons of the most popular types of
smart-beta indexes that have been introduced in recent years.
Fundamentally Weighted Indexes
In a fundamentally weighted index, stocks are weighted
in proportion to their fundamentals, such as book value or
earnings. In other words, instead of letting the market decide
on the appropriate weight of a stock, one might say that
fundamentally weighted index investors prefer to rely on
the assessment of accountants. The differences in weights
between a traditional, capitalization-weighted index and a
fundamentally weighted index are, by definition, entirely
due to differences in valuation ratios of individual stocks,
such as differences in book-to-price or earnings-to-price
ratios. Compared with the capitalization-weighted index, a
fundamentally weighted index is tilted toward stocks that are
cheap on such ratios, i.e., value stocks. Studies have shown
that the added value of fundamentally weighted indexes
is, in fact, entirely attributable to this tilt toward the value
premium. 3 For a long time, Research Affiliates, the inventors
of fundamentally weighted indexation, denied that the
success of fundamentally weighted indexation is critically
dependent on the existence of a value premium. Instead,
they argued that, even in the absence of a value premium,
random mispricing causes capitalization-weighted indexes
to be biased toward overvalued stocks, resulting in a structural
drag on performance. 4 Nowadays, however, Research
Affiliates acknowledges that the value premium does indeed
explain most or all of their indexes’ performance. 5
Our main concern with straightforward value strategies
such as fundamentally weighted indexation is that they
tilt toward financially distressed firms. To understand this,
consider a firm that actually gets into financial distress. As a
result, its share price drops, and its weight in the cap-weighted
index drops correspondingly. Initially, the same happens
in a fundamentally weighted index. At a certain point, however,
a fundamentally weighted index rebalances back to the
weight based on past and current fundamentals, which have
typically not (or only partly) adapted to the new situation.
This exposure to distressed firms might not be a problem
if, as some have conjectured, distress risk is the source of
the value premium. Studies have shown, however, that the
stocks of financially distressed firms tend to underperform,
and that the tilt to distressed firms of naive value strategies
increases risk and is harmful to returns. 6 This implies that
the value premium can be captured more efficiently by
avoiding cheap stocks of financially distressed firms.
A related concern is that, since rebalancing involves
buying stocks that have recently experienced a large price
drop, fundamentally weighted indexes tend to go against the
momentum premium. As the momentum premium appears
to be at least as strong as the value premium, this suggests that
the return of a value strategy may be enhanced by avoiding its
natural tendency of going against the momentum premium.
Another concern with fundamentally weighted indexes
is their sensitivity to settings choices. For example, it has
been shown that, in certain calendar years, the arbitrary
choice of the annual rebalancing moment of the fundamentally
weighted FTSE RAFI indexes can make the difference
between an outperformance of 10 percent or a small
underperformance. 7 The more recently launched fundamentally
weighted indexes of MSCI, called MSCI Value
Weighted indexes, address this concern by rebalancing
every six months, while those of Russell rebalance a quarter
of the portfolio every quarter. In light of these developments,
FTSE recently announced that it will also provide
such a staggered quarterly rebalanced variant of the FTSE
RAFI indexes this year, although these will not replace their
current indexes but will coexist with them.
Finally, we note that fundamentally weighted indexes
represent a low-conviction approach to capturing the value
premium. To understand this, note that a fundamentally
weighted index is not exclusively concentrated in stocks with
the most attractive valuation characteristics. For example,
the FTSE RAFI US and Developed ex-U.S. indexes each
invest in 1,000 stocks, and the MSCI Value Weighted indexes
invest in all the stocks that are in the regular MSCI indexes.
In other words, stocks with the least attractive valuations are
still included in these indexes, only with smaller weights.
Low-Volatility Indexes
Low-volatility indexes are designed to benefit from the
low-volatility premium: the empirical finding that low-risk
stocks have similar or better returns than the market average,
with substantially lower risk. Minimum-volatility indexes use
optimization techniques to create a portfolio with the lowest
expected future volatility. The resulting portfolio tends to
consist mainly of stocks with low past volatility, although it
may also include some higher-volatility stocks if these help
www.journalofindexes.com March / April 2013 37