Smart Beta or Smart Alpha?

Abstract

Smart beta has become the flavor of the decade in the investment world with its low fees, easy access to rewarded risk premiums, and appearance of providing good investment results relative to both traditional passive benchmarks and actively managed funds. Although we consider it well documented that smart beta investing probably will do better than passive market capitalization investing over time, we believe many are coming to a conclusion too quickly regarding active managers. Institutional investors are able to guide managers through benchmarks and risk frameworks toward the same well-documented smart beta risk premiums and still motivate active managers to avoid value traps, too highly priced small caps, defensives, etc. By constructing the equity portfolios of active managers that resemble the most widely used risk premiums, we show that the returns and risk-adjusted returns measures are not only superior to the common capitalization weighted index but also to their smart beta benchmark, even after cost for value, size, and low volatility funds. We encourage investors to increase the use of smart beta as benchmarks while still obtaining extra performance through active management—a concept we call smart alpha.

TOPICS: Analysis of individual factors/risk premia, equity portfolio management, performance measurement