Smart beta, strategic beta and alternative beta are popular buzzwords in the investment world. Do these terms all mean the same thing?
“It’s a little bit hard to pin down,” says David Blitzer, chairman of the index committee at S&P Dow Jones Indices.
“There’s some confusion in the industry,” adds Tony Davidow, the alternative beta and asset allocation strategist at the Schwab Center for Financial Research.
“Every version of alternative beta I’ve seen is not market-cap weighted,” says Blitzer. “But there is not too much that I’ve found that is common across the range.”
For advisors, the choices among alternative beta portfolios are numerous, including equal weighting of stocks in an index, selecting an index’s least volatile stocks, and fundamental weighting. The latter can use a single factor, such as dividends, or multiple factors including cash flow, sales, book value, dividends and share buybacks.
ALTERNATIVE BETA VS. CAP-WEIGHTED INDEX FUNDS
Because they use factors that change over time, maintaining alternative beta portfolios requires more work and more frequent updates than simply tracking a plain vanilla cap-weighted index. As a result, they can carry considerably larger expense ratios than traditional index funds, though expenses are much lower than those of managed portfolios.
The cost disadvantage vs. cap-weighted index funds doesn’t matter much if the performance of alternative beta justifies it. “They have historically generated pretty significant excess returns,” says Davidow.
Blitzer, who leads the group that picks stocks for the most-tracked cap-weighted index, the S&P 500, is less emphatic about alternative beta. “Depending on market conditions, it may give you better returns than a market-cap weighted index,” he says.
SMART ALLOCATION
The alternative beta strategy with the longest live record (as opposed to a backtested record) is the S&P 500 Equal Weight Index. Over the past decade it has outperformed its cap-weighted sibling. “What the equal weight does is pretty clear,” says Blitzer. “It’s going to overweight small stocks and the value stocks tend to be smaller.”
The net result is that the S&P 500 Equal Weight looks a lot like a mid-cap index. Critics note that over the past decade mid-cap stocks outshined their larger brethren. Will equal weighting, or any other non-cap-weighed methodology, still look good when large-cap stocks lead the pack?
David Blitzer recommends building a portfolio around core cap-weighted indexes, with a slight overweight to large-cap. He sees alternative beta as more peripheral.
Tony Davidow suggests that fundamental strategies should be 50% of large-cap holdings with the rest allocated to managed and cap-weighted funds. In less efficient markets he would recommend a greater allocation to managed funds.
“I think we’re relatively early in the development of these alternative beta strategies,” says Davidow, adding, “There’s still room for innovation here.”
