Issue 28: 2014

Web Exclusive — Investment Strategy

The Evolution of Smart Beta

A brief investigation into the origins of this growing investment platform.

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As we explain in this issue’s article "Getting to Know Smart Beta" smart beta investing is an increasingly popular alternative to traditional active and passive investing. But where did today’s strategies come from? Here’s a brief history.

The 1960s

  • In the 1960s, the capital asset pricing model (CAPM) approach to analyzing portfolios by breaking down returns into alpha (risk-adjusted excess return versus the market) and beta (sensitivity to the market) gained popularity.
  • Within this framework, the over- or under-performance of a stock could be attributed to its beta (high or low, respectively), as a reward for assuming market risk.
  • During this period, U.S. equity portfolios were primarily allocated across various U.S. large cap stocks.

The 1970s and 1980s

  • The 1970s brought international investment to the masses, and following the discovery of the small cap effect (a theory that smaller companies tend to outperform their larger peers), the 1980s further expanded the investment universe to include small cap stocks.
  • Eventually, emerging markets entered the arena as well.
  • Along the way, growth and value style investing was also adopted as a way to classify stocks and add value relative to the overall market.

The 1990s

  • In 1992, financial economists Eugene Fama and Kenneth French introduced the Fama-French three-factor model, which maintained, among other things, that the main factors affecting a stock’s return were market, size and style, rather than solely beta, as the CAPM approach maintained.
  • This dramatically shifted long-standing views on market risk and returns. By demonstrating that value stocks and small cap stocks tended to outperform the market over long periods of time, Fama and French upended the prevailing investment wisdom and opened up the possibility that there could be other undiscovered factors that offered an opportunity for strong returns over long horizons of investment.
  • Indeed, other factors (e.g., momentum and profitability) were subsequently identified and used to enhance the Fama-French multifactor model.
  • All these discoveries, which showed persistent excess returns based on readily identifiable characteristics, helped to lay the groundwork for what are now referred to as smart beta indices.

The 2000s

  • In 2005, Robert Arnott, Jason Hsu and Philip Moore of Research Affiliates authored what would come to be regarded as a landmark paper on fundamental indexation, which argued for passive equity investing based on certain fundamental factors (dividends, free cash flow, sales and book value), rather than merely market capitalization.
  • Shortly thereafter, the Financial Times Stock Exchange (FTSE) and Research Affiliates teamed up to create the Research Affiliates Fundamental Indices (RAFI).
  • Several other major index providers — MSCI, Russell, S&P Dow Jones — also provided their own smart beta indices, which focused on an increasingly wide variety of factors — and on certain combinations of factors.

For more on smart beta investing, contact your advisor.

IMPORTANT INFORMATION

Investing involves risk. There is always the potential of losing money when you invest in securities.

Always consult with your independent attorney, tax advisor, investment manager and insurance agent for final recommendations and before changing or implementing any financial, tax or estate planning strategy.

OTHER IMPORTANT INFORMATION

Equities
Equity securities are subject to stock market fluctuations that occur in response to economic and business developments.

International Investing
International investing involves special risks, including foreign taxation, currency risks, risks associated with possible differences in financial standards, and other risks associated with future political and economic developments. Investing in emerging markets may involve greater risks than investing in more developed countries. In addition, concentration of investments in a single region may result in greater volatility.

As we explain in this issue’s article "Getting to Know Smart Beta" smart beta investing is an increasingly popular alternative to traditional active and passive investing. But where did today’s strategies come from? Here’s a brief history.

The 1960s

  • In the 1960s, the capital asset pricing model (CAPM) approach to analyzing portfolios by breaking down returns into alpha (risk-adjusted excess return versus the market) and beta (sensitivity to the market) gained popularity.
  • Within this framework, the over- or under-performance of a stock could be attributed to its beta (high or low, respectively), as a reward for assuming market risk.
  • During this period, U.S. equity portfolios were primarily allocated across various U.S. large cap stocks.

The 1970s and 1980s

  • The 1970s brought international investment to the masses, and following the discovery of the small cap effect (a theory that smaller companies tend to outperform their larger peers), the 1980s further expanded the investment universe to include small cap stocks.
  • Eventually, emerging markets entered the arena as well.
  • Along the way, growth and value style investing was also adopted as a way to classify stocks and add value relative to the overall market.

The 1990s

  • In 1992, financial economists Eugene Fama and Kenneth French introduced the Fama-French three-factor model, which maintained, among other things, that the main factors affecting a stock’s return were market, size and style, rather than solely beta, as the CAPM approach maintained.
  • This dramatically shifted long-standing views on market risk and returns. By demonstrating that value stocks and small cap stocks tended to outperform the market over long periods of time, Fama and French upended the prevailing investment wisdom and opened up the possibility that there could be other undiscovered factors that offered an opportunity for strong returns over long horizons of investment.
  • Indeed, other factors (e.g., momentum and profitability) were subsequently identified and used to enhance the Fama-French multifactor model.
  • All these discoveries, which showed persistent excess returns based on readily identifiable characteristics, helped to lay the groundwork for what are now referred to as smart beta indices.

The 2000s

  • In 2005, Robert Arnott, Jason Hsu and Philip Moore of Research Affiliates authored what would come to be regarded as a landmark paper on fundamental indexation, which argued for passive equity investing based on certain fundamental factors (dividends, free cash flow, sales and book value), rather than merely market capitalization.
  • Shortly thereafter, the Financial Times Stock Exchange (FTSE) and Research Affiliates teamed up to create the Research Affiliates Fundamental Indices (RAFI).
  • Several other major index providers — MSCI, Russell, S&P Dow Jones — also provided their own smart beta indices, which focused on an increasingly wide variety of factors — and on certain combinations of factors.

For more on smart beta investing, contact your advisor.

IMPORTANT INFORMATION

Investing involves risk. There is always the potential of losing money when you invest in securities.

Always consult with your independent attorney, tax advisor, investment manager and insurance agent for final recommendations and before changing or implementing any financial, tax or estate planning strategy.

OTHER IMPORTANT INFORMATION

Equities
Equity securities are subject to stock market fluctuations that occur in response to economic and business developments.

International Investing
International investing involves special risks, including foreign taxation, currency risks, risks associated with possible differences in financial standards, and other risks associated with future political and economic developments. Investing in emerging markets may involve greater risks than investing in more developed countries. In addition, concentration of investments in a single region may result in greater volatility.