The recent months have seen a wide proliferation of the term “smart beta,” which in its simplest terms indicates an index construction that does not weight constituents by market capitalization but incorporates some type of rules-based rebalancing process. A wide array of strategies are starting to have live performance histories greater than five years, and we evaluated the WisdomTree Indexes focused on U.S. equity markets with at least that much history. What are these various smart beta index strategies really doing when one looks under the hood?
Some have called smart beta just “small-cap tilted.” Some have called smart beta just repackaged value strategies, and others have even referred to it as making an active bet on the market. We undertook a rigorous regression analysis to help explain factor loadings of various indexing strategies to quantify how big a “bet” these strategies are making on various factors, which can help explain their return patterns and underlying strategy.
What Factors Drive Smart Beta?
Professors Eugene Fama and Kenneth French developed a factor-based approach to analyzing the performance of a particular investment strategy or index. In essence, there are four factors, each meant to have some degree of explanatory power over returns. It’s important to note that this analysis is wholly dependent upon the period of study:
• Market: This factor is meant to denote exposure to the market’s “risk premium”—a figure that is calculated by looking at the equity market’s return minus the risk-free rate. Higher values here indicate an increased sensitivity to potentially amplify the impact of market movements.
• Size: This factor is meant to denote exposure to different market capitalization size segments. More negative values indicate exposure to the larger capitalization size segments, whereas more positive values indicate exposure to smaller capitalization size segments.
• Value: One of the most widely referenced strategy style distinctions is the differentiation between “value” or “growth” exposure, as each can have a very unique risk/return profile. In these results, a more positive figure indicates a greater sensitivity to the value style, whereas a more negative figure indicates a greater sensitivity to the growth style.
• Momentum: One factor that has received attention more recently is momentum, which measures the propensity of an investment strategy to capture different trends exhibited by the market. A more negative value here indicates essentially a lack of momentum, whereas a more positive value indicates a greater potential sensitivity to this factor.