Can Beta be Smart?

Factors, multi-factors, smart beta, strategic beta, and whatever else you want to call non-market-cap-weighted investing is everywhere.

I don’t think it is plausible to go one week without hearing mention of smart beta if you work anywhere near ETFs. As the ETF industry (and even some mutual funds and stock pickers) expands the menu of smart beta options, some users of traditional market cap products may feel ostracized by the smart beta movement. It is important to remember ETFs are tools to express views; understanding their risk and return as a result of their weighting methodology is paramount.

Smart beta and factor investing are inexplicably tied together, as many smart beta ETFs typically take advantage of one or more systematic return factors. We typically look at the “big six” factors as being the most widely accepted and academically supported. So how do factors, and their smart beta brethren, outperform over time?

Simply put, to outperform the broad market cap index over time you need to gain more by outperforming on the way up, the way down, or some combination of the two. Many factors’ long-term outperformance can be attributed to losing less than the broad market index.

The chart below shows the MSCI “big six” factors for the U.S. (back to 1993) and ACWI (back to 1999). It illustrates their degree of outperformance if the returns in negative months were replaced with returns of the parent index (either MSCI U.S. or MSCI ACWI). As you can see, four of the six factors attribute a portion of their outperformance over time to downside mitigation.

In fact, all of the outperformance (and then some) of minimum volatility is attributable to downside mitigation. This is to be expected given the nature of the factor, but just imagine if some of that downside cushion disappeared (a discussion for another time).

Now, adjusting an index by replacing its bad months with something else is a bit like saying we would have won the basketball game if we hadn’t missed so many shots. That being said, there are many observations that can be made from this adjustment. The adjusted returns of value and momentum, two of the most heavily studied factors (and used in many ETFs) indicates that those factors tend to underperform in down market periods. This leads us to ponder, are there instances where broad market-cap exposure can be a smart decision, even from a factor standpoint?