Is Smart Beta About to Get Smarter?

Smart beta strategies occupy an intriguing area between active and passive management, often combining the best of both, says Morningstar's Al Kellett

Alastair Kellett 27 March, 2013 | 4:33PM

As the debate rages on between proponents of traditional market-cap weighted indexing and those that espouse alternative weighting schemes, the EDHEC-Risk Institute is venturing further into the fray as it prepares to launch a series of indices that seek the advantages of existing smart beta methodologies while managing some of their inherent risks.

In previous articles we have examined the broad characteristics of alternative weighting strategies. Critics of smart beta often make the observation that many such approaches create biases. Fundamental indexing, for instance, typically tilts portfolios towards small (or relatively smaller) companies and value stocks. It’s not hard to see why that might be the case: whereas market cap indices are heavily influenced by the largest companies and those whose shares have appreciated as a result of optimistic growth prospects, smart beta strategies often sell themselves precisely on the idea that they represent an alternative to that.

The existence of such biases is no small revelation. Small- and mid-cap stocks have historically been riskier than large caps, and value stocks may go through prolonged periods of under appreciation and underperformance relative to their more growth-oriented peers. As part of what it is calling “Smart Beta 2.0,” EDHEC is trying to refocus the smart beta discussion onto these types of risk. For example, if a certain fundamental indexing strategy displays a bias towards small cap value stocks, EDHEC essentially asks the question of what would happen if we tweaked that methodology by starting with a universe of only large, growth companies and then running the same model. If other smart beta strategies tended to overweight certain industries, similar tweaks could reduce the tracking error of such strategies by starting with sector neutrality and only then letting the model select stocks to fill each industry bucket.

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About Author

Alastair Kellett

Alastair Kellett  is an ETF analyst with Morningstar Europe.

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