Monday, September 9, 2019

Alternative weighting schemes and smart beta - Comparing Sharpe ratios

Can investors improve upon a cap-weighted equity benchmark? This is a fundamental question for many investors. It is also one of the foundational issues for smart beta products that use different passive weighing schemes. Hat tip to Adam Butler of @GestaltU for referencing this piece of older research by Nick Motson of the Cass Business School in London. Motson did exhaustive work on the issue and produced some compelling conclusions. (See Smart beta, Scrabble, and Simian Indices)

There are strong theoretical reasons for alternative weighing scheme but for most investors it is an empirical issue on whether it works over a long-run period with different return environments. It is hard for any investor to change benchmarks and of course any new benchmark has to be compared to the old standard, but the Motson work provides some interesting food for thought. The smart beta alternatives generally have higher Sharpe ratios, lower volatility, and alpha versus a market-weighted benchmark although there is no alpha versus a Fama-French framework. Alternative schemes can have high correlation with a classic cap-weighted index, but there can still be significant tracking error and return dispersion over short time periods. 

Of course, all of these alternative indices have one thing in common; they reduce the exposure to the largest cap stock names. Still, for investors who want some simple ways to systematically change equity risk exposure, the smart beta benchmarks are alternatives worth exploring. Note that these products will have higher fees and more transaction costs, so there is a question on how to effectively implement or structure portfolios to generate the intended result. It can be as simple as adding more exposure to lower market cap names.

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