‘Smart Beta’ an Approach to Investing?
The term ‘Smart Beta’ is a catchy title for an increasingly significant approach relating to exchange traded products (ETPs). Particularly its potential ability to outperform standard benchmark indexes has resulted in its market appeal and growth. However with its expansion warrants the necessity to educate investors, in order to understand the suitability, benefits and limitations of this approach.
Limitations with previous approaches?
Before we analyse the foundations of smart beta approach, an understanding of why it has emerged is essential. As with all progressions and new approaches within the financial industry, the smart beta approach has gained popularity as an alternative due to flaws
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It would then rebalance when needed i.e. buying and selling of stocks, to help revise weightings to reflect changes in the index over time. This result in an adverse selection as more weighting will continue to be allocated to large companies such as CBA that have a higher price is higher.
On the other end of the spectrum choosing an active approach presents its own issues. Finding consistent performing active fund managers who can deliver returns greater than the market is very rare. According to Standard & Poor’s SPIVA Australia scorecard in 2012, approximately 69 percent of active retail Australian equity funds failed to beat the S&P/ASX Accumulation index and 72 per cent of active international equity funds failed to beat the benchmark. This coupled with high premiums charged for active management and lack of transparency in managing processes diminishes the appeal of active management approach further.
Understanding Smart Beta
The ‘smart beta’ approach should be more accurately described as ‘strategic beta’ as it aims on improving the flaws of passive index based approaches. It has become an umbrella term for alternative weighting and factor based investing. In essence you take an active approach to choosing the rules to base your fund. But once set, the rules passively
Some modifications of the beta coefficient are the adjusted beta and the fundamental beta. The former tries to transform the historical beta closer to an average beta of 1.0. The latter seeks to incorporate information concerning the company to achieve a better estimate for beta. Moreover, beta values out of less-developed financial markets are not good estimates and therefore partly biased. Problems in estimating beta for divisions of a corporations could arise if the divisions are too small and therefore can be compared with less-developed financial markets. Hence, beta coefficients could be biased (Brigham & Daves, 2007).
DFA’s investment strategy is based on their belief in the principle that stock market is efficient. They attempt to match a broad-based, value-weighted small-stock index and position themselves in the market as a passive fund manager that still claimed to add value by capturing specific dimensions of risks identified by financial science. DFA’s investment strategy incorporates elements of both passive and active management. It is passive in the sense that like many other index managers, it focuses on the importance of diversification, lower turnover and lower fees than actively managed portfolios. It is active in the sense that it develops its small-value stock focus based on academic research and uses certain techniques (such as
The behaviour of markets and investors, the decision making in the market place and the dynamics of demand and supply in any given market cannot be determined with a hundred percent accuracy. However master minds in the past have designed various techniques and theories that help investors make a particular buying decision, or to make choices logically. These theories and techniques help today’s investors to peep into the future and make almost immaculate predictions regarding the future behaviour of the market and the ongoing trends. A lay man night view the decision making of an investor as being solely based upon speculation but in reality every move that an investor makes today in the market place is backed up by sound calculation and
After levering the equity beta, the asset beta of the firms are calculated. As mentioned we think that the three discount brokerages (highlighted in green) should be used as comparables for Ameritrade. The average asset beta of the three firms is 1.386. As a comparison the investment services firms have average asset beta of 0.603 and the one internet company (Mecklermedia) for which enough historical data is
Here we choose VW NYSE, AMEX, and NASDAQ data as market returns, because it’s value weighted and more reliable. The results show CSC’s equity beta = 2.27, QRG’s equity beta = 1.79.
Our approach is an active security selection with passive asset allocation. We invest heavily in common stocks, but vary our holdings to include companies of all sizes and industry groups. We seek to achieve sufficient diversification by abstaining from investing more than 5% of the total assets in a single security unless it has significant upside potential, and we make an exception for ETFs and index funds as they represent a basket of securities. Our main goal is to identify and invest in common stocks with high potential for both short- and long-term capital appreciation. Our secondary goal is to invest in common stocks with steady income. When potential for rewards are high, we also enter into derivative
* Stock Beta: Exhibit 5 shows a detailed measurement of the company’s stock returns in relation to the rest of the market through 5-year historical price and index data. The analysis includes monthly returns of both the NYSE and the S&P 500 index in order to capture a comprehensive view of the market return. In each comparison, the monthly returns of the Target stock and market are plotted on Y-axis and X-axis respectively to get the regression line’s slope or beta. The analysis arrives at an average beta of 0.988 which indicates a similar movement of Target stock’s returns in comparison to the whole market over time.
An individual stock's diversifiable risk, which is measured by the stock's beta, can be lowered by adding more stocks to the portfolio in which the stock is held.
If you are a new investor who is interested in investment history or how to make investments, purchase this book by Burton G. Malkiel. This book is ideal for any experienced investor who wants to brush up on their knowledge of investment techniques and theories also. There are not many books that have been written about investing. A Random Walk Down Wall Street is broken down into four parts which include; Stocks and Their Value, How the Pros Play the Biggest Game in Town, The New Investment Technology and A Practical Guide for Random Walkers and Other Investors. In total, there are fifteen chapters that cover a lot of key points that many will find interesting and informative.
Definition: In an active portfolio strategy, a manager uses financial and economic indicators along with various other tools to forecast the market and achieve higher gains than a buy-and-hold (passive) portfolio.
Beta: is seen as an ‘index of responsiveness’ of changes in a security’s returns relative to changes in returns on the market, in this case is sport utility industry)
By using the company return and the Value Weighted Returns of the Market, we derived the companies’ levered equity betas and then unlevered them.
To find the asset Beta (βa), we need to find the weighted average β of equity and the weighted average β of debt. We consider the β of debt to be 0, as debt has no relationship with market risk and it is evident from the balance sheet that Ameritrade had no interest bearing debt in 1997[1].
For estimation of betas, the above equation was run for the period from Jan, 2003 to Dec, 2006. Based on the estimated betas we have divided the sample of 63 stocks into 10 portfolios each comprising of 6 stocks except portfolio no.1, 5 and 10 having seven stocks each. The first portfolio 1 has the 7 lowest beta stocks and the last portfolio 10 has the 7 highest beta stocks. The rationale for forming portfolios is to reduce measurement error in the betas.
With the investment strategy and the actual risks being considered, several issues in investment are likely to occur for Beta management Company. First, it is crucial to evaluate how profitable is each of the stocks being considered and given an option, which company should Beta choose. Secondly, it is also imperative to assess how profitable it is to increase the portfolio equity exposure to 80%. To evaluate the investment decisions, it is imperative to thus explore how the company manages its investments and the nature of its investment