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For illustrative purposes only. Source: Morningstar Direct
 
The rise in popularity of smart beta investment strategies is no secret. There has been a lot of literature written on the topic and new products launched. What you may not know is that smart beta may not be such a novel idea and that these strategies may just be disguised as portfolios with small cap and value tilts.

For example, take equal weighted portfolios. The image above is a graphical representation of a market-cap weighted U.S. equity portfolio. Notice how companies like Apple (AAPL), Exxon (XOM), and Microsoft (MSFT) stand out in the picture. Also notice how Large Growth (LG) dominates the scene.
 
Chart2
For illustrative purposes only. Source: Morningstar Direct
 
Now look at the image above which constitutes the same universe of companies but equally weighted. Now there aren’t any stand-out names and the image is dominated by small cap companies. Large cap bias is gone as they make up roughly 1/3 of the image.
 
From these two images it is easy to see that an equal weighting strategy has a tilt towards small cap companies. And research by Fama and French show that firms with more exposure to small cap companies will have a higher expected rate of return over the long term than portfolios with exposure to large cap companies.1 Increased exposure to small cap and value companies is likely the explanation of outperformance of many smart beta strategies vs. their market-cap weighted counterparts.2
 
Although smart beta may be the current craze in the investment world, it may be nothing new. In fact, Chow, Hsu, Kalesnik, and Little show that many of the popular smart beta strategies outperform their cap-weighted counterparts largely owning to exposure to value and size factors.3 The smart beta craze may be nothing more than tilts to value and small cap companies — something that has been part of our investment philosophy here at Loring Ward for more than 20 years.
 
For more information on smart beta strategies, check out our latest research report: “Are You Smarter than a Smart Beta?” If you have access to Loring Ward’s MyAdvisorCenter you can find it under Communications>Marketing>White Papers.
 


1Fama, Eugene, and Kenneth French. 1993. “Common Risk Factors in the Returns on Stocks and Bonds.” Journal of Financial Economics, vol. 33, no. 1 (February):3-56.
2Xydias, Alexis, “Smart Beta ETFs Beating S&P 500 Index Capture Record Cash,” www.bloomberg.com, March 5, 2014.
3Chow, Tzee-man, Jason Hsu, Vitali Kalesnik, and Bryce Little. 2011. “A Survey of Alternative Equity Index Strategies.” Financial Analysts Journal, vol. 67, no. 5(September/October):37-57.
 
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The risks associated with investing in stocks and overweighting small company and value stocks potentially include increased volatility (up and down movement in the value of your assets) and loss of principal.
 
Small company stocks may be subject to a higher degree of market risk than the securities of more established companies because they may be more volatile and less liquid.