The Smart Beta 2.0 Approach - EDHEC-Risk

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An ERI Scientific Beta Publication — Smart Beta 2.0 — April 2013
Copyright © 2013 ERI Scientific Beta. All rights reserved. Please refer to the disclaimer at the end of this document.
Appendix: Overview of Smart Beta Equity Portfolios
(this is sometimes called the 1/N rule). For example, an equal-weighted version of the
S&P 500 would use the same 500 constituents as the cap-weighted version of the index
but it attributes an equal weight of 0.2% to each constituent. These equal-weighted
benchmarks are attractive because they avoid the concentration and trend-following of capweighted
indices and typically lead to higher Sharpe ratios compared to their cap-weighted
counterparts (DeMiguel, Garlappi and Uppal, 2009, Platen and Rendek, 2010). However,
for investors to adopt an equal weighting scheme is an extreme stance since it implies that they
would accept to give up on any form of fundamental or statistical analysis to gather useful insights
about the stocks’ characteristics. In fact, the equal-weighted portfolio would have the highest
possible Sharpe ratio if and only if pairwise correlations, volatilities and expected returns were
identical for all stocks.
Equal-weighting is a simple way of “de-concentrating” a portfolio and allows us to benefit from
systematic rebalancing back to fixed weights. Depending on the universe and on whether
additional implementation rules are used, the rebalancing feature of equal-weighting can be
associated with relatively high turnover and liquidity problems. Maximum Deconcentration
can be perceived as a generalisation of a simple equal weighting scheme, the aim being to
maximise the effective number of stocks defined as the inverse of the Herfindahl index (see
footnote four):
Maximum Deconcentration minimises the distance of weights from the equal weights subject to
constraints on turnover and liquidity. In addition, investors may have the option to add constraints
on tracking error, sector weight deviations or country weight deviations with respect to the capweighted
reference index.
In the absence of any constraints, Maximum Deconcentration coincides with the equal-weighting
(also known as the “1/N” weighting scheme), which owes its popularity mainly to its robustness
and it has been shown to deliver attractive performance despite highly unrealistic conditions of
optimality, even when compared to sophisticated portfolio optimisation strategies (De Miguel,
Garlappi and Uppal, 2009).