Beta gets strategicContributor Yazann Romahi
Refining a traditional concept to blaze new trails to portfolio diversification
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. Smaller stocks for example, are riskier investments, more highly geared to the local economy, as opposed to global trends. Thus they can provide a diversifying source of returns. Embedding a bias towards value stocks looks to counteract the nature of traditional indices, which can be susceptible to the formation of bubbles as momentum-driven stocks become a larger and larger part of the index.
Diversifying across return sources
Adding such nuanced sources of return to a portfolio aims to achieve several benefits. New return streams offer additional sources of diversification. Since they all have their own economic basis, they tend to perform at different times. If one is underperforming, then it is likely that another continues to perform. To judge from smart beta’s explosive growth, the approach has an intuitive and powerful appeal.
Yet despite the recent explosive growth, the research that underpins these ideas is not new. Indeed, ever since the creation of the first index, academics have continued to refine our understanding of sources of economic return. Today, in equities, we are more nuanced in our definition of sources of market return and these fall into 4 broad categories: the value premium, the small cap premium, momentum as well as quality (or minimum volatility).
Roadmap for a smoother ride
Diversifying exposures by combining betas, the systematic and routine gains expected from a diversified set of investments that access an economic risk premium, tends to preclude the occasionally spectacular upside possible in active management, just as it tends to hedge against the disastrous loss possible from the concentration risk inherent to traditional passive cap-weighted indexes. It may provide a stable core, which has a comparatively steady and predictable source of returns. For the long-term investor, that is a potential route to asset growth.