Evaluating Alternative Beta Strategies
Journal of Indexes Europe, March/April 2012
18 Pages Posted: 27 Sep 2012
Date Written: February 1, 2012
In recent years, there has been a proliferation of alternatively weighted (“alternative beta”) indices, such as fundamentally weighted indices, equal-weighted indices and low-volatility indices. We have surveyed a broad range of alternative beta strategies that have gained significant traction in the investment community.
Although alternative beta strategies aim to achieve better risk-adjusted performance than cap-weighted portfolios, we find that they are often constructed with more specific objectives in mind. These objectives include achieving a systematic value tilt, lowering portfolio volatility or reducing stock-specific risks, and may define the essence and main applications of different strategies.
Some recent studies suggest that all alternative beta strategies have exposure to the value and small-cap factors, which explains their outperformance over the market. However, we find that, while the examined alternative beta strategies are to a large degree driven by the well-known equity risk factors (market, value, small-cap, momentum and volatility), the primary factor drivers of individual strategies are often distinct, and in turn may define the risk and return profile of the strategy.
These findings suggest that when evaluating an alternative beta strategy, a starting point for investors may be to examine its objective and risk drivers in the context of those investors’ own investment objectives and preferences for risk-taking.
When it comes to implementation, our analysis suggests that portfolio construction methodologies can have significant implications for the risk and return profiles of alternative beta strategies, and should therefore be examined carefully. Implementation costs, as well as simplicity and transparency, may also be considered important evaluation criteria.
We caution that alternative beta strategies often take substantial active risks, which are largely driven by their factor exposures. As factor returns can be volatile over time, all alternative beta strategies may experience periods of significant underperformance relative to the cap-weighted market portfolio. However, as common equity risk factors may not be correlated, we find that combining alternative beta strategies that are driven by distinct sets of risk factors may significantly reduce active risk and improve the information ratio.
Keywords: Alternative Beta Strategies, Quantitative Equity Strategies, Portfolio Construction, Alternative Index Strategies, Alternatively Weighted Indices, Fundamental Indices, Low Volatility Strategies, Minimum Variance Strategies, Equal Weight Indices, Equal Risk Contribution
JEL Classification: G10, G11, G14
Suggested Citation: Suggested Citation