Smart Beta Strategies
Low Risk Anomaly and Diversification
Smart Beta in asset allocation
Are smart beta passive or active strategies?
Smart Beta is the answer of asset management industry to some well know drawbacks of market capitalization-based equity indices as price noise, overrepresentation of large caps, absence of auto-corrective mean reversion mechanism. Some of these features may result in high volatility and massive drawdowns, thus potentially compromising the risk return payoff of traditional equities, at least when the investment horizon is shorter than 8-10 years.
In this study we provide a formal description of three popular risk-based smart beta strategies (the minimum variance portfolio, the portfolio maximizing the diversification ratio, and the risk parity portfolio), providing some insights in terms of composition. Specifically we point out that all of them provide some interesting diversification enhancement relative to standard indices, and all of them contain low systematic risk characteristics. But still they exhibit different features that can be exploited in a diversified alternative beta allocation, as well as in some timing or rotation strategy.
We show that “low market beta” and the “low risk anomaly” explain a relevant portion of the variability of the active returns of the minimum variance strategies, with some variance explained by “sector reversal” and “dividend yield”. Yet the unexplained variability corresponds to some non-negligible positive contribution to performance, while filtering the universe for some quality criteria provides additional value. As for the diversification-based strategies, “low market beta” and “low risk anomaly” are still the more significant factors, with the addition of “small cap” and “sector reversal”. “Small cap” and “sector reversal” are the most relevant factors for risk parity strategies, while “low beta” and “low risk anomaly” are less explanatory.
If the investor’s relevant risk measure is absolute risk, smart beta may become a “new equity core”. In this case, however, liquidity of smart beta strategies must be consistent with the amount of assets the investor holds.
We finally discuss whether these strategies should be considered as passive or rather active strategies.
Mean-variance efficient portfolios are optimal as Modern Portfolio Theory alleges, only if risk were foreseeable, that is under the hypothesis that price (co)variance is known with certainty. Admitting uncertainty changes the perception. If portfolios are presumed vulnerable to unforeseen price shocks as well, risk optimality is no longer obtained by minimising variance but also pertains to the diversification in the portfolio, for that provides protection against unforeseen events. Generalising MPT in this respect leads to the double risk-objective to minimise variance and maximise diversification. We demonstrate that a series of portfolio construction techniques developed as an alternative to MPT, in fact address this double objective, under which Bayesian optimisation, entropy-based optimisation, risk parity and covariance shrinkage. We give an analytical demonstration and provide by that new theoretical backing for these techniques. Amundi Working Paper December 2016 (First version)September 2017 (Revised version)
Marielle de JONG
Head of Fixed Income Quantitative Research at Amundi
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