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How “Smart” is Your Beta?


As a Chartered Financial Analyst*, each spring I look forward to CFA Institute’s annual conference, where I have a chance to hear the latest insights of internationally known investment managers and economists. One of the most popular topics at this year’s conference was what is referred to as “Smart Beta,” or “Alternative Indexing.” Smart Beta/Alternative Indexing approaches are departures from traditional methods of indexing that allow us to better manage portfolio volatility and risk-adjusted return, i.e. get “more” for our Beta. (Beta refers to an investment’s volatility relative to the market as a whole. A security with a Beta equal to 1 is regarded to be as volatile as the market, while a Beta of .5 indicates that a security is half as volatile as the market and a Beta of 1.5 indicates that a security is 1 ½ times more volatile.)

What is Traditional Indexing?

Before we can talk about newer methods of indexing, let’s review what is now called Traditional Indexing. One of the most well-known stock market indexes is the S&P 500. This index is a capitalization-weighted index, which means that the weight of one company relative to the other companies it tracks corresponds directly to the market value of the company. (Capitalization is simply the number of a company’s outstanding shares of stock multiplied by the market price per share.) As an example, in the S&P 500 a company valued at $20 billion would have twice as much weight as a $10 billion company.

How is Alternative Indexing Different?

Essentially, the term Alternative Indexing refers to any way to weight an index’s positions other than using market capitalization. You are probably familiar with the Dow Jones Industrial Average; it uses a method called price-weighting, which means that the index weights are based strictly on share price. A $50 stock would have twice as much weight as a $25 stock. In contrast to Traditional Indexing, price-weighting ignores the number of a company’s outstanding shares. The price-weighting method was developed and used in the days before computers because it was relatively easy to calculate the value of the index on a daily basis. It is rarely used on new indexes.

Equal-weighting is another well-known Alternative Indexing method. In an equal-weighted index, each stock has exactly the same weight. For example, if the index tracks 50 companies, each company’s stock represents 2% of the index, regardless of share price or capitalization.

How Does This Affect How We Manage Your Investments?

Because Traditional Indexing weights the stocks with the highest market values most heavily, by design it over-weights the most overvalued securities and under-weights the most undervalued securities. This results in a less than optimal portfolio – holdings are skewed towards companies that are more likely to be overpriced. We think that this is akin to buying high and selling low, and we seek funds that have the potential to participate in more of a stock’s potential growth.

Over the years, researchers and portfolio managers noticed that some indexing strategies demonstrate consistently better returns than traditional capitalization weighted indexes – with the same or, sometimes, even less volatility. The challenge was to figure out what factors were responsible for this (the “Smart” part of “Smart Beta”), then separate them out and develop indexes around them.

There are now many strategies that use these non-traditional factors, including strategies that combine multiple factors. One of our favorites is an approach referred to as Fundamental Indexing. Although firms may define Fundamental Indexing in different ways, they generally rely on business factors at each company – such as sales, earnings, dividends, and cash flows – to decide which stocks to include in the index. The goal is to target business activities that have real economic impact, not just what the market says the company is “worth.” Historically these strategies have produced higher returns than cap-weighted indexes, with similar risk. Achieving higher return relative to risk is known as producing “Alpha.”

Another strategy that we utilize focuses on “High Quality” companies, or as Morningstar describes, those that have “wide economic moats.” These companies tend to have strong cash flows, low debt, and most importantly, strong market positions (moats) that make it hard for their competitors to take business away.

In both cases, the stocks are chosen using a formula rather than traditional corporate analysis, which reduces cost. Thus, another advantage of these strategies is that in addition to attractive risk-adjusted return, they generally have lower cost. Essentially these strategies are in an area between active (mutual fund managers) and passive (Traditional Indexing) management.

What Does This Mean for You?

We have incorporated alternative indexing strategies into most of the accounts we manage; we think that this approach will outperform traditional indexing with about the same amount of risk.

If you have questions or would like more information about any of these please contact me. The direct dial number to my desk is (865) 342-4444.

*The Chartered Financial Analyst (CFA®) designation is a globally recognized professional credential awarded by the CFA Institute. Chartered Financial Analysts must pass a series of examinations and demonstrate the highest level of commitment to professional ethics and expertise. The CFA curriculum is widely considered to be the most difficult exam on Wall Street.


Meet the Author

David A. Zandstra, CFA

Chief Investment Officer

Dave is the Chief Investment Officer at Meridian and responsible for the overall investment strategy and selection process.  He graduated from Calvin College in Grand Rapids, Michigan with a degree in business administration and received his MBA from Heriot-Watt University in Edinburgh, Scotland.

Dave is a member of the Knoxville Estate Planning Council, the CFA Institute and the CFA Society of East Tennessee. In addition, he is a board member of the CFA Society of East Tennessee and the Foothills Land Conservancy and serves as Treasurer for American Youth Soccer Organization Region 796.

Originally from the Chicago area, Dave started his career in the Trust department of First Chicago Bank.  After working there for several years, Dave and his wife Karlyn decided to explore and work across the country for a year and a half. Eventually they decided to settle down and chose Knoxville for its climate, low cost of living, and (not wanting to be flatlanders anymore) proximity to the mountains. Dave worked for seven years as a Portfolio Manager in the Trust department of First Tennessee Bank before joining Meridian in 2004.