By Yazann Romahi via Iris.xyz
The investment industry is abuzz with talk of smart beta, and many are touting it as a revolution in passive investing. In reality, it is simply the latest iteration in an evolution of a 100-year-old concept. It offers, in essence, an improvement on the first and most important property of an investment portfolio: diversification.
The concept of the average market return existed as early as the 19th century when the Dow Jones Industrial Average was created. Prior to the development of investible indexes, investors attributed 100% of a fund’s return to manager skill (“alpha,” as it would later come to be known). “Beta” embodies the idea that investors could earn a positive return, or equity risk premium, simply for holding a large number of risky securities — “the market” in other words. The concept was still alien to the investment community when John C. Bogle launched the Vanguard 500 Index Fund in 1975. With time, it became clear that a significant portion of return was driven by exposure to the equity risk premium.
Escaping the mega cap trap
Market cap weighted indexes have dominated indexation since the introduction of the concept of beta. The performance of indexes of this kind is heavily dependent on the performance of the largest stocks, as shown in the chart below. An attempt to avoid concentration in mega-caps led to the next innovation in index investing: smart beta. By systematically seeking to maximize diversification, smart beta broke the link between index weights and market capitalization. A further innovation looked to explicitly embed factors other than raw equity beta, such as low volatility or value.
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