Smart Beta vs Alpha + Beta

Simplifying Equity Portfolios

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

SUMMARY

  • Investment portfolios can be simplified by separating alpha from beta
  • Alpha + beta portfolios offer higher risk-adjusted returns than smart beta
  • The main hurdle for better portfolios is investor behaviour, not a lack of products

INTRODUCTION

In Buddhist teaching, the primary obstacles that prevent us from ascending to a higher state are ignorance, greed, and anger. This trio of poisons not only keeps us from evolving as people but also as investors.

Most investors still believe we can outperform the market through our stock-picking skills. We remain in this state of ignorance despite ample and available evidence. We also tend to be greedy and to chase performance when selecting securities. And our investment decisions, which should be made as dispassionately as possible, are often influenced by our emotions, anger among them.

This is not a recipe for success.

Just as meditation can focus and clarify the mind, simplification can do the same for most investment portfolios. A single ETF representing the whole stock market could satisfy the equity allocation of a balanced portfolio. If outperformance is a mandate requirement, then factor investing, among other systematic and research-backed strategies, could be among our options.

But factor investing has its own complexities. Since the financial crisis, a wave of single- and multi-factor smart beta products have become available. Yet these are neither fish nor fowl, just long-only index products with factor tilts (read Multi-Factor Smart Beta ETFs).

More recently, mutual funds and ETFs have been launched that give investors direct access to the long-short multi-factor portfolios described in factor investing’s foundational literature. These are the real thing.

So can we create a simple and clean equity portfolio by separating alpha from beta? And what can we do about the innate human weaknesses that sabotage our investment decisions?

FACTOR INVESTING IN THE US STOCK MARKET

While research shows stock-picking is mostly a losing game, over time, factor investing ha