Smart beta strategies are effective at isolating and capturing risk premia, according to Scientific Beta, a commercial venture of EDHEC Risk Institute. The firm’s latest research paper, “Smart Beta is not Monkey Business”, confirms that investors are able to use smart beta investment products, such as certain exchange-traded funds, to achieve specific factor exposures.
“Smart Beta is not Monkey Business”, released by Scientific Beta, rejects the notion that a randomly-generated portfolio would on average provide the same performance as a smart beta-weighted portfolio.
The paper investigated claims that all smart beta strategies gain exposure to the size factor and that any out-performance is solely attributable to this exposure, and that similar results may be obtained by a random, so-called “monkey” weighting strategy. The monkey label comes from the idea that a monkey would be able to generate similar performance through a random selection of stocks.
The paper analysed these claims using test portfolios which follow commonly-employed methodologies for explicit factor-tilted indices. The results directly invalidate all of the above claims. In particular, the results show that many smart beta strategies display exposure to factors other than value or small cap, as well as pronounced differences in factor exposures across different strategies.
Additionally, the paper maintains that randomly-generated strategies on average provide inferior performance compared to their smart beta benchmarks, owing to their inability to successfully capture risk premia. As an illustration, the researchers compared the historical performance of the inverse of each strategy to its original. For example, where a traditional volatility strategy would assign greater weight to lower volatility stocks, its inverse assigns the most weight to the highest volatility stocks. The findings directly contradict the monkey smart beta portfolio claim with certain approaches providing excess returns above 3% per annum compared to their inverse.
The research did acknowledge, however, that indices termed “fundamental” may behave like monkey portfolios because their method of construction is based on accounting criteria that are not associated with any statistically significant risk premium over the long term. This observation points to the importance of carefully assessing the appropriateness and robustness of a particular smart beta strategy, especially as the use of the term smart beta is broad and, in some cases, stretched.