By Razann Romahi, via Iris.xyz
Portfolio management relies heavily on a single premise: asset returns may vary but diversification rarely fails. Clearly the outcome of many small events is in aggregate more predictable and less risky than the impact of a single large one. The rationale justifies the concept of investing in a broad index of stocks to capture the generally upward trend of the market as a whole—what we commonly refer to as beta. Beta investing, by encompassing the whole market, has a high degree of transparency—it’s “the market,” after all—and by eliminating the research and decision-making that go into choosing one stock over another, it has the further attraction of low management fees.
Traditional diversification relies on a market cap weighting scheme. Naïve diversification in this manner carries a risk all its own, however: the market’s leaders outpace its laggards so that the negative consequences on a portfolio, if and when the leaders stumble, are correspondingly greater. This momentum effect embedded in the index also means that stocks that become more and more expensive, take an increasingly larger weight in the index. Smart beta arose in large part to address this problem. In effect, smart beta adds layers of systematic diversification to a conventionally diversified portfolio to gain exposure to beta-like returns from investing in a group of stocks exhibiting common economic characteristics that are known to capture specific returns.
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