Andy wrote a recent article entitled Smart Beta Gains Momentum. It’s gaining momentum for a good reason! A recent study at Cass Business School in London found that cap-weighting was not a very good way to construct an index. Lots of methods to get exposure to smart beta do better. The results were discussed in an article at Index Universe. Some excerpts:
Researchers have found that equity indices constructed randomly by ‘monkeys’ would produce higher risk-adjusted returns than an equivalent market capitalisation-weighted index over the last 40 years…
The findings come from a recent study by Cass Business School (CBS), which was based on monthly US share data from 1968 to 2011. The authors of the study found that a variety of alternative index weighting schemes all delivered superior returns to the market cap approach.
According to Dr. Nick Motson of CBS, co-author of the study, “all of the 13 alternative indices we studied produced better risk-adjusted returns than a passive exposure to a market-cap weighted index.”
The study included an experiment that saw a computer randomly pick and weight each of the 1,000 stocks in the sample. The process was then repeated 10 million times over each of the 43 years. Clare describes this as “effectively simulating the stock-picking abilities of a monkey”.
…perhaps most shockingly, we found that nearly every one of the 10 million monkey fund managers beat the performance of the market cap-weighted index,” said Clare.
The findings will be a boost to investors already looking at alternative indexing. Last year a number of European pension funds started reviewing their passive investment strategies, switching from capitalisation-weighting to alternative index methodologies.
Relative strength is one of the prominent smart beta methodologies. Of course, cap-weighting has its uses—the turnover is low and rebalancing is minimized. But purely in terms of performance, the researchers at Cass found that there are better ways to do things. Now that ETFs have given investors a way to implement some of these smart beta methods in a tax-efficient, low-cost manner, I suspect we will see more movement toward smart beta in the future.