The Smart Beta Indexing Puzzle

Abstract

In this article, we consider smart beta indexing, which is an alternative to capitalization-weighted (CW) indexing. In particular, we focus on risk-based (RB) indexing, the aim of which is to capture the equity risk premium more effectively. To achieve this, portfolios are built which are more diversified and less volatile than CW portfolios. However, RB portfolios are less liquid than CW portfolios by construction. Moreover, they also present two risks in terms of passive management: tracking difference risk and tracking error risk. Smart beta investors then have to a puzzle out the trade-off between diversification, volatility, liquidity and tracking error. This article examines the trade-off relationships. It also defines the return components of smart beta indexes.

Keywords: Smart beta, risk-based indexing, minimum variance portfolio, risk parity, equally weighted portfolio, equal risk contribution portfolio, diversification, low beta anomaly, low volatility anomaly, tracking error, liquidity

JEL Classification: G11