In this video, we are going to discuss smart beta strategies and smart beta ETFs, which are implementations of the screening strategies that we discussed in a previous set of slides. Again, recall there is mixed evidence on the efficacy of fundamental analysis, which is the traditional way that investment managers identified outperforming stocks. Meanwhile, there has been considerable evidence that signal-based strategies, that is to say, strategies based on firm specific variables, outperform standard benchmarks. These strategies use firm-specific information such as ratios, forum portfolios on the basis of these signals, or on the basis of these ratios. Portfolios formed on these signals tend to co-move and hence are often referred to as factor portfolios.
So for example, all high book-to-market stocks tend to do well or poorly at similar times. To refresh the way we implement such a strategy, is first to sort companies by some signal which we’ll call x. Again, x could be a ratio such as the ratio of book value of equity to market value of equity, or it could be some characteristic of the firms such as its market capitalization. Or alternatively, it could be a measure of historical performance, such as return over the past 12 or six months. We sort based on the signal and then find the stocks that perform well on the signal, and hold portfolios according to value weights.
For example, a portfolio sorted on a single signal might wind up having several 100 firms. The investor has to research the signals themselves, and as signals update, the investor has to rebalance the portfolio. As a result, these types of investment strategies may be very difficult to access for individual investors. This is where the idea of signal-based, or smart beta, or factor beta investing has come in. MSCI, for example, has constructed a number of factor indices that are based on this concept.
The indices allow tracking of exposure to a single signal, for example, the book-to-market ratio, such that investors could invest in a portfolio of stocks that are just high book-to-market, exposure to multiple signals such as size and book-to-market, such that investors could track small and high book-to-market firms, or tilts toward signals, which we will clarify further in a little bit. These indices are typically compared to some parent index. For example, we might have as parent index the S&P 500, and consider as our signal portfolio, stocks that are high book-to-market within the S&P 500. There are two main types of smart beta strategies, and the ETFs generally represent one of two kinds. The first are standards smart beta indices.
In this case, the ETF is going to hold a portfolio that is based on one or multiple signals. These ETFs would hold only index constituents that performed well on these signals. So therefore, if the signals I was considering were profitability and book-to-market ratio, it would only hold those constituents that were both profitable and high book-to-market. The second type is smart beta tilts. In this case again, we will hold a portfolio that is based on one or multiple signals. However, in this case we’ll hold all index constituents. So the portfolio, if it’s based on the S&P 500, would hold all of the stocks in the S&P 500.
However, the weights will differ from the weights in the S&P 500, where the weights will tell more heavily toward stocks that perform well on the signals, than those that perform poorly. Again, using book-to-market ratio and profitability as an example, high book-to-market and profitable firms will be weighted more heavily, whereas low book-to-market and less profitable firms will be weighted more lightly. Smart beta ETFs are designed to implement the screening methods that we have discussed in previous videos. The advantage to these types of ETFs is that individual investors, who normally would have difficulty implementing the strategies, have access to quantitative active investment strategies. These ETFs are typically available as an absolute strategy or a tilt.
In the case of an absolute strategy, again, an investor is going all out on an individual signal or a set of signals, and in a tilt, it is a more conservative tilt towards the signal or signals. In the next video, we’ll talk about an example of how an absolute strategy index would be constructed, and therefore an absolute strategy ETF.