The Education of Beta: Can Alternative Indexes Make Your Portfolio Smarter?

Abstract

Alternatives to traditional cap-weighted indexes have been growing in popularity as investors strive to add diversification using a transparent, mechanical, and low-cost approach. Alternative index strategies, sometimes called smart beta, promise enhanced return, often with lower risk and greater diversification power. We examine a number of such strategies and find that many feature persistent tilts (especially to value and small-cap stocks), which account for the majority of their risk and return characteristics. Because alternative index strategies reweight stocks from the same universe, diversification with standard benchmarks has been very weak. Investors can use alternative index strategies to capture factor tilts instead of relying on active management, or they can reallocate assets out of cap-weighted index strategies to a middle ground between traditional passive and active. Although past performance results have been strong, there is no reason to expect future outperformance from these strategies unless the embedded tilts continue to be rewarded. For those who really believe in factor tilts (such as value and small cap), risk-premia strategies—which can invest across multiple asset classes and permit short selling— are far more compelling than single-asset-class, long-only alternative index strategies.

TOPICS: Mutual funds/passive investing/indexing, portfolio construction, factor-based models