Smart Beta

Question 1

What are the main investment styles?

Answer 1

• Value:
  
  • Identifying efficent firms that are inexpensive and undervalued verus their intrinsic value. Evidence from long-run returns suggest that value stocks have greater expected return.
  • Value stocks have higher book to price and therefore usually lower beta, which should make them less risky and should make value investing appealing to most types of investors.
  • Low beta should mean low returns, so higher returns is an anomaly of the EMH.
  • The strategy is generally based on mean reversion.
• Momentum:
  
  • Buying stocks that have had high returns over past periods and selling those that have had poor returns over the same period.
  • This should not be easily exploitable in a relatively efficient market.
  • Investors might be taking higher risk and are compensated for higher return or they are explioiting behavioural shortcomings in other investors.
  • MOMO is a 4th factor found in explaing long term returns in Carhart Model.
• Growth:
  
  • Involves identifying securites with rapid growth prospects often at an early stage of development and might focus on small cap where ther is less analst coverage.
  • Also might be in large cap stocks where their growth expectations are larger than the market expects. Might include EM, TECH, SMALL or Spec Sits.
  • Growth stocks have lower PTB and usually higher beta so might be more risky.

Question 2

What is Smart Beta?

Answer 2

• Alternative indices that provide low cost non-market cap weightings and re-weight consituents of certain factors. They are constructed differently from market cap indices, it is not enhanced indexecation.
• The aim is to gain exposure to a factor that has delivered incremental returns that will hopefully persist. Smart beta aims to systematically exploit factors.
• One must be mindful whether the increased return is just a compensation for higher risk or if it is a true anomaly.
• Investors must ask themselves if a particular vehicale is well-designed to exploit the anomaly of if it wll persist.
• E.g. some do fade such as the weekend effect or value.
• Smart beta provides an alternative that frees up a portion of the risk budget and allows for more diversification.

Question 3

What are the merits and drawbacks of smart beta?

Answer 3

• Merits:
  
  • Opportunity to follow a long-run investment anomaly such as high dividend stocks, low P/E or MOMO.
  • Not procyclical so potentially lower risk in times of market downturns.
  • Can have lower and more stable correlation to other assets so may provide more diversifcation.
  • May of the smart beta indices are by design underweight the largest stocks in the market cap universe, therefore if biggest drop in the biggest stocks, alternative beta indices will outperform.
• Drawbacks:
  
  • Higher fees and charges
  • Higher and unknown annual turnover because the individual constituent weights are determined endogenously by an optimiser.
  • Unclear when to rebalance the index.
  • If they become popular and everyone follows the anomaly will presumably disappear. There is evidence of reducing anomaly size such as day of the week effect and momentum.
  • There are some concerns that the anomaly exists only as a back-test that the index was created by datamining rather than discovering a persistent structural effect.
  • Liquidity can be a concern and some indices are more liquid than others.