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Smart beta: Eyes on the prize

By: Yvette Murphy, senior product manager

In the first part of two blogs about the accessibility of smart beta, I stated that smart beta indexes do not have to be complex, and we discussed two examples of smart beta index construction that were intuitive and simple to understand. In this blog, I want to look at how these alternatively weighted methodologies have fared when compared to a more traditional market cap weighted index. I’ll also examine whether the method of their construction achieved the desired objectives.

It’s important to remember that the performance of smart beta indexes must be assessed within the context of their stated objectives – return enhancement, volatility reduction or increased diversification. The two smart beta index examples we used in the earlier blog were equal weighted and fundamentally weighted. The objective of the former is increased diversification, and the objective of the latter is to enhance returns by selecting securities by fundamental factors.

We can see in the chart below that when compared to the cap weighted Russell 1000 Index, both the Russell 1000 Equal Weight Index and the fundamentally weighted Russell RAFI US Index outperformed over the period presented. However, did the two smart beta indexes achieve their objectives of greater diversification and improved fundamentals?

One way of assessing whether equal weight indexes achieve their objective of increased diversification is to look at the concentration in the top 10 constituents. As of May 31, the weight in the top 10 constituents in the Russell 1000 Index is predictably high at 15.9%, dominated by familiar large technology and financial names such as Apple, Microsoft, Facebook, JPMorgan and Wells Fargo. Likewise, we would expect similar levels of concentration for the Russell RAFI US Index, given strong fundamentals are highly correlated with high market value. By comparison, the Russell 1000 Equal Weight Index demonstrates much higher diversification, with only 2.4% of the total index weight attributed to the top 10 constituents. 

To determine if the Russell RAFI US Index managed to attain its goal of improved fundamentals overall, we can compare its primary fundamental measures with those of the cap weighted index. As we can see in the chart below, with the exception of the price earning ratio, the Russell RAFI US Index improved on each of its fundamental measures.

While these two intuitively constructed smart beta indexes might not always outperform their cap-weighted counterparts, they do achieve their specified objectives. Indexes that are constructed differently from a standard cap-weighted index will likely perform differently in various market environments, so market participants should always consider their own objectives and risk considerations. Smart beta indexes simply provide alternative means of focusing on specific objectives without being overly complex.

For more detail on this subject please see our paper: The intuitive foundations of smart beta.

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