Low beta investing definition

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Economist Harry Markowitz first theorized smart Beta via his work on modern portfolio theory. Smart beta emphasizes capturing investment factors or market inefficiencies in a rules-based and transparent way. The increased popularity of smart beta is linked to a desire for portfolio risk management and diversification along factor dimensions, as well as seeking to enhance risk-adjusted returns above cap-weighted indices.

Smart beta strategies seek to passively follow indices, while also considering alternative weighting schemes such as volatility , liquidity, quality, value, size and momentum. That's because smart beta strategies are implemented like typical index strategies in that the index rules are set and transparent. Key Takeaways Smart beta seeks to combine the benefits of passive investing and the advantages of active investing strategies. Smart beta uses alternative index construction rules to traditional market capitalization-based indices.

Smart beta strategies may use alternative weighting schemes such as volatility, liquidity, quality, value, size and momentum. Selecting Smart Beta Strategies There is no single approach to developing a smart beta investment strategy, as the goals for investors can be different based on their needs, though some managers are prescriptive in identifying smart beta ideas that are value-creating and economically intuitive.

Equity smart beta seeks to address inefficiencies created by market-capitalization-weighted benchmarks. Funds may take a thematic approach to manage this risk by focusing on mispricing created by investors seeking short-term gains, for example. Managers may also choose to create or follow an index that weights investments according to fundamentals, such as earnings or book value, rather than market capitalization.

Alternatively, managers may use a risk-weighted approach to smart beta that involves the establishment of an index based upon assumptions of future volatility. For instance, this may involve an analysis of historical performance and the correlation between an investment's risk relative to its return.

At first blush, it may seem that investors would be well-advised to sell high beta stocks and buy low beta stocks. However, before employing any investment strategy one should always think deeply about the reasons for the performance of the strategy and draw upon those explanations to form a thesis on whether or not the performance will continue to persist.

An irrational preference for high beta stocks, borrowing constraints, and tracking error volatility constraints are the three main explanations for the failure of the CAPM to predict returns. I discuss each of these in turn. This drags down the required return on high beta stocks to a lower level than that which is predicted by the CAPM, and pushes up the required return on low beta stocks to a higher level than that which is predicted by the CAPM.

One of the assumptions of the CAPM is that investors can borrow unlimited amounts of capital. In reality, various government regulations prohibit investors from borrowing unlimited amounts of capital and the availability of lendable funds varies widely over the business cycle.

This limits the ability and willingness of investors to employ leverage in their investment portfolios. Consider an investor who desires to take a leveraged position in a broadly diversified portfolio of stocks and relies solely on the CAPM in estimating the required return on stocks. In the absence of a reliable source of lendable funds, such an investor would instead take an unlevered position in a portfolio that is constrained to high beta stocks.