Wednesday, August 19, 2015

The Smart Beta Dilemma

The debate about whether smart beta strategies add value vs. market cap weighted indices will probably never end.  Smart beta strategies continue to launch with impressive backtested results that show outperformance over market cap weight.  The main questions revolve around whether those backtests are curve fitting and/or anomalies and whether that outperformance can persist.

If you are a long term buy and hold asset allocator then this presents a problem.  You are benchmarked against market cap weighted indices so any allocation to smart beta involves risk of underperformance.  You have to be sold on the backtest and the idea that any outperformance will be persistent.  If you are right you might add alpha, if you are wrong then you have a problem.

Tactical asset allocators don't have that problem.  Whether any smart beta idea is an anomaly or not isn't as relevant if you are not going to buy and hold something for ever.  The only relevant issue is whether or not a smart beta idea has periods where it outperforms a relevant market cap weighted index and how volatile that performance is.  Using relative strength or absolute momentum models of smart beta along with market cap weighted products allows the tactical investor to switch back and forth between smart beta and market cap weight (or cash in the case of absolute momentum).  Whether the outperformance will persist over the long term isn't relevant as long as it persists long enough for the tactical investor to make money and isn't so volatile that it moves down faster than a tactical model can exit.  

For the tactical investor, smart beta is another tool in the toolbox.  Maybe smart beta strategies are better than  market cap weighted indices, maybe they are not, but they do give tactical investors another set of assets to use in their models.

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