How Smart is Smart Beta Investing? Evidence from Australia

Abstract

"Smart beta" investing is an alternative to the traditional active and passive approaches to funds management, whereby investors adopt a systematic method that provides exposure to factors that are argued to be related with expected returns at low cost. Therefore, the question of how smart is smart beta investing can be empirically examined by testing the performance of those factors that underlie smart beta portfolios. We use a long time-series of data and show that the value, momentum, low volatility and quality factors all generate positive abnormal returns in the Australian equity market. Rather than ranking these factors based on relative performance, we argue that the optimal approach to smart beta investing is to diversify across these factors, given the low correlations between factor returns. Our results provide important implications for the Australian funds management industry. First, while this study does not examine the specific strategies applied by smart beta fund managers, the evidence presented provides a justification for the application of smart beta as a low cost alternative to active investment. Second, given evidence that multiple factors explain equity returns, multi-factor models should be used to measure active portfolio manager performance in order to distinguish pure alpha from abnormal returns generated due to smart beta exposure.

Keywords: Smart beta, funds management, value, momentum, volatility, quality

JEL Classification: G12, G14