Smart Beta

Beta, in the investing universe, is a measure of risk relative to a chosen benchmark. For example, if a stock has a beta of 1 vs. the S&P 500, it should move just as far up (or down) as the index itself does. The definition and calculation of investment indices have numerous components (see our previous discussion in Investment Strategies). The S&P 500 stock index is composed of the 500 largest companies (as defined by their market capitalization) in the US. The company’s market capitalization is determined by multiplying the number of corporate shares outstanding times the price of the stock. That calculation results in a relative concentration of large companies. In fact, the top 10 companies in the index (2% of the 500 companies) comprise approximately 17% of the index.

In April, 2005, a group of researchers (Rob Arnott, Jason Hsu, and Philip Moore) posited in the Financial Analysts Journal that there were better measures of a company than its market capitalization. They claimed to “show that the fundamentals weighted, non-capitalization based indexes consistently provide higher returns and lower risks than the traditional cap-weighted equity market indexes while retaining many of the benefits of traditional indexing.” They felt that measures such as revenues, book value, sales, dividends, cash flow, etc. should be better measures used in valuing a company. The basic intent was to decouple the price of a stock with its weight in an investment portfolio. That coupling, according to them, results in excessive holdings of large cap stocks in the funds that track a capitalization weighted index.

This fundamental weighting has led to a significant number of new “smart beta” or fundamental weighted mutual funds or exchange traded funds (ETFs). Some strategies are return oriented seeking to increase returns over a standard benchmark by using company revenue, earnings, momentum, size, etc. Other strategies seek to modify the risk level vs. the benchmark by employing other strategies.

There is significant disagreement among financial professionals about the usefulness of such strategies. In fact, are they truly “indexing” or another form of active management? Smart beta has generated a lot of interest in terms of new funds and ETFs; however are they sound investment principles or “marketing hype?” There are proponents on each side of the argument. The jury is still out on the final decision.

Smart beta investments usually charge a higher expense ratio than standard indexing investments; the investment methodology is usually more complex. That fee is in the 25-40 basis point range.

We, at Paragon Financial Advisors, believe you should invest in those things which you understand—and which lead to the attainment of your financial goals at your accepted risk level. We’ll be glad to discuss your investment options with you.  Paragon Financial Advisors is a fee-only registered investment advisory company located in College Station, Texas. We offer financial planning and investment management.

               

Investment Strategies

There has been much discussion about investment strategy. Is an active management strategy (where the investor or an investment manager actively selects the investments in the portfolio) or a passive strategy (simply trying to replicate a broad market index with selected investments) the better choice? Or does the best answer lie somewhere in between (a semi-active portfolio). Our attempt here is simply to discuss both. The ultimate decision lies with the individual investor.

 

Passive Investing
Passive investing usually involves trying to replicate the performance of some broad market index. The S&P 500 is one of the most common stock indices. If one chooses the passive approach, one should know the characteristics of the underlying investment. For example:

1. How well does the index represent the desired asset population?
2. What is the criteria for inclusion in the index (i.e. the specific characteristics of the stocks desired in the index universe)?
3. How are the stocks weighted in the index?
4. What is the computational method used in the index (i.e. does the index represent only the price change in the included stocks or does it include dividends (total return))?

Let’s look at index weighting. Stock in the index can usually be weighted in the following manner:

1. Price Weighted- Each stock is weighted by its absolute price. A stock priced at $50 has twice as much weight in the index as a $25 stock. The index construction is relatively simple; however, there is obviously a price bias.
2. Value (Market Capitalization) Weighted- Each stock is weighted according to the company’s market capitalization (the company’s price per share times the number of shares). The bias here is toward large capitalization companies. This bias can result in a less diversified portfolio concentrated in a relatively few companies. The S&P 500 is composed of the 500 US stocks with the largest market capitalization; however, the top 10 (2%) companies comprise about 17% of the index.
3. Equal Weighted- Each stock is weighted equally in the index. In this case, small companies have the same weight as large companies.

The dominant passive approach is indexing. This approach assumes the financial markets are fairly priced with few opportunities for mispricing. The turnover in the portfolio is low (changing only when the index composition changes) and the internal expenses are generally low. The most popular investment vehicles are index mutual funds and exchange traded funds (ETFs).

Active Investing

 Active investing assumes there are strategies which can be used to yield a higher return the market index. Such strategies usually assume: 1) holding more of the higher return companies in the index, or 2) holding less of the lower return companies in the indices. This active strategy can include segmenting the market (growth stocks, value stocks, large cap stocks, small cap stocks, international stocks, etc.) and using complimentary investing strategies (selling stock short, using options, derivatives, etc.).

Which Is Best?

Much has been written and numerous academic studies have been conducted to answer that question. There have been periods when each method has been the better performer. Consider the “lost decade” in stocks. On January 3, 2000, the S&P 500 index was approximately 1468; on December 29, 2009 it was approximately 1114. However, in between it reached a low of 681 (March, 2009) and a high of 1565 (October, 2007). Therefore, indexing for that decade would have lost money. Active management could have yielded gains in the decade.

A more reasonable approach might be temper maximized investment returns with the client’s risk tolerance and the return necessary to reach the client’s goals. We, at Paragon Financial Advisors, will help our clients identify and realize this balance.  Paragon Financial Advisors is a fee-only registered investment advisory company located in College Station, Texas. We offer financial planning and investment management.