Given the amount of criticism smart-beta investing has faced lately, new research confirming its outperformance should be a welcome change. Unfortunately even that comes with a sting.
A new paper has demonstrated the superiority of these strategies, which attempt to blend the best of active and passive with a quant approach known as factor investing, usually wrapped in exchange-traded funds.
However, researchers concluded the outperformance has next-to-nothing to do with those quantitative methods, which weight shares based on characteristics like measures of cheapness or the dividends they pay. Instead, excess returns stem entirely from how funds periodically adjust their holdings.
“The outperformance of these strategies is completely explained by the diversification returns embedded in the portfolio rebalancing inherent in all such strategies,” wrote academics Wenguang Lin from Western Connecticut State University and Gary C. Sanger from Louisiana State University. “Efficient factor tilts explain none of the outperformance.”
In other words, smart beta’s edge over a strategy of simply weighting shares based on their market capitalization comes not from being smarter, but from making more changes.
The study is the latest broadside against the booming $1 trillion smart-beta industry, which accounts for more than a fifth of U.S. ETF assets. Its promise of delivering sophisticated quant strategies at a lower price continues to lure investors, even amid swirling doubts about the effectiveness of factor investing and performance that has lately disappointed.
The new paper surveyed the returns of 1,000 U.S. stocks over four decades, built portfolios based on fundamental metrics including value, sales, dividends and cash flow and tested various weighting approaches.
The researchers then used the difference between each share’s individual volatility and the portfolio’s volatility to add a parameter known as diversification return.
The idea is that the act of reshuffling the portfolio to maintain certain exposures -- as opposed to a passive buy-and-hold-the-index approach -- increases diversification. That reduces the risk of the portfolio, meaning its compound returns are greater than the sum of its parts.
“We propose that all alternative weighting schemes, through their embedded periodic rebalancing, generate significant diversification returns relative to the traditional cap-weighted benchmark,” Lin and Sanger wrote. “In fact, we show that all of the outperformance of these alternative investing strategies is due to the diversification return.”