Is smart beta still smart?

Decades later, questions emerge about the approach to enhancing returns using factors

Andrew Willis 27 May, 2019 | 2:00PM

Strategic beta (often called smart beta), or factor investing, entered the scene as a source of alpha that sought to distance human emotion from trading decisions. A rational approach, with a foundation built on decades of data and academia, sounds compelling. But we recently heard doubts and decided to dig into them.

Strategic beta emerged as an investment strategy to take advantage of the empirical failures of the Capital Asset Pricing Model or CAPM. According to the CAPM, a stock’s expected return should be proportional to how much it follows the ups and downs of the market (beta). The higher the systematic (non-diversifiable) risk of an asset, the larger the potential returns over the long run. Since its creation in the mid-1960s, the CAPM has been widely influential, winning one of its creators, William Sharpe, the Nobel Prize in Economic Sciences in 1990. However, starting in the late 1970s, researchers discovered factors other than beta that can predict risk and returns.

“[CAPM] fell short of explaining all stock returns – it could not explain small cap or cheap stocks – and this gave rise to the F-F 3 [Fama and French Three Factor Model]” says Prithy Serrao, Director of Business Development at SmartBe Wealth, an ETF provider that focuses exclusively on factor-based products. Add in an assessment of size and value, and you’re able to explain over 90% of portfolio returns, says Serrao.

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Andrew Willis

Andrew Willis  Andrew Willis is a content editor for Morningstar.ca.

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