The Triumph of Mediocrity: A Case Study of 'Naïve Beta'
Posted: 7 Apr 2015
Date Written: March 31, 2015
In contrast to factor-based “smart beta”, diversification-based “smart beta” assumes that, seemingly “naively”, all investments are just average or the same in some dimension. The four possible dimensions: portfolio weight, expected return, risk-adjusted return, and risk contribution, lead to four “naïve beta” portfolios respectively: equal-weight, minimum variance, maximum diversification, and risk parity portfolios. In this paper, we show how these four portfolios outperform the capitalization-weighted S&P 500 index due to their sector differences and especially, the index’s aggressive shifts into specific sectors. Among the three “naïve beta” portfolios that use risk inputs as part of their portfolio construction, both minimum variance and maximum diversification portfolios tend to be highly concentrated in certain sectors. We develop an analytic framework based on a partitioned correlation matrix, modeling sectors as two groups (mostly defensive versus cyclical). The results shed light on material differences between the risk parity and optimized portfolios in their level of diversification across the sector and stock dimensions. Empirical examples of sector and stock portfolios within the universe of the S&P 500 index show the triumph of “naïve beta” over the index, which suffers from strong sector biases and ill-timed allocation shifts.
Keywords: Portfolio Theory, Naive Beta
JEL Classification: G11, C61
Suggested Citation: Suggested Citation