Most of the outperformance of smart beta can be explained by diversification returns embedded in rebalancing. The value-added is just good old diversification and rebalancing. Keep it simple. This conclusion is the interesting result from the paper "Is smart beta still smart under the lens of the diversification return?" by Lin and Sanger that has finally been published. The work should make any investor think twice about paying a fee premium for some of these smart beta products.
The foundation behind this work is from older research developed in the early 1990's by Booth and Fama and Fernholtz and Shay in the 1980's on diversification returns. The average compounded return is the weighted average geometric returns from the stocks in the portfolio and the diversification return which is half the different between the weighted sum of individual stock variances and the portfolios variance. This return is a portfolio version of geometric returns which is the arithmetic return minus the variance drag. This return calculation concept is learned early in the study of investments.
Given this simple concept, the diversification return effect can be measured. An improvement in diversification return can occur if both portfolio and individual asset variances are controlled or minimized. The authors look at different weighting schemes applied at the industry and at the stock level inside an industry grouping. These can be used to make comparisons with the classic value-weighted index and equal weighted within and across industries. The set of alternative weighting schemes are included in the table below.
The figure below shows the results from the author's analysis. The cap-weighted index underperforms the other weighting schemes based on geometric returns calculated over the long period tested. Using alternative weighing scheme reduces risk of large losses and improves the Sharpe ratio. The driver of returns is the diversification rules.
We have recently posted "Thinking about diversification in an uncertain world" which focused on Charlie Munger's comment that diversification works for the "know-nothing" investor and that the goal of investing is to find investments where it is safe not to diversify. This smart beta work still reinforces that argument. It makes perfect sense to push the value of diversification as far as possible. Get as much free lunch from diversification first and then use skill if available to take specific risks.
Strong cap-weighted index performance this year does not change the core results for this study. The big tech names have dominated the economy and asset recovery, but in a more normal world diversification will still win over the long-run.
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