How to Allocate Smartly to Smart Beta

Takeaway versus Home-Cooked Investing

June 2019. Reading Time: 10 Minutes. Author: Nicolas Rabener.

SUMMARY

  • Single factor excess returns are attractive over the long-term, less in the short-term
  • Comparing popular asset allocation models does not highlight one superior methodology
  • Multi-factor portfolios generated excess returns in two out of three regions since 2008

INTRODUCTION

Obesity rates in countries like the US or New Zealand are north of 30%, which increases health issues such as diabetes and effectively reduces life expectancy. The citizens of these countries should do everything within their powers to reduce their daily calorie intake.

Unfortunately, new companies like Uber Eats are making it more convenient to order takeaway food, which tends to be less healthy, more expensive, and contain more calories than when cooking at home.

Factor investors face a similar choice between buying ready-made multi-factors products or creating these themselves. Multi-factor ETFs might be a convenient solution for harvesting returns from various factors, but these are more costly than single factor ETFs and are often challenging to analyze.

Alternatively, investors can directly select single factor products and create custom portfolios, either by allocating on a discretionary or systematic basis. The simplest form of the later might a portfolio that allocates equally across smart beta strategies, but it is questionable if that is an optimal allocation model.

In this research note, we will apply four well-established asset allocation models to smart beta strategies and evaluate if smart beta would have enabled investors to outperform the markets (read Smart Beta Asset Allocation Models).

OUTSMARTING THE MARKET

The rise of factor investing is based on the broad effort to make investing more scientific, which has become easier given cheaper, better data and new technologies. Research by academics and finance professionals principally supports five factors namely Value, Size, Momentum, Low Volatility, and Quality. Dividend Yield can be considered a (poor) version of Value while Growth is a widely-followed investment style, but lacks backing from research.