Is Smart Beta Still Smart under the Lens of the Diversification Return?

Abstract

The diversification return is known to explain a significant portion of portfolio growth rates. Separately, results from backtesting have created significant interest in smart beta portfolio strategies. Extant research shows that smart beta strategies outperform the passive value-weighted benchmark due to their implicit risk factor tilts, such as value and size. This article reexamines the performance of a subset of smart beta strategies, known as fundamental indexing, focusing on the diversification return. The authors demonstrate that the outperformance of these strategies is completely explained by the diversification returns embedded in the portfolio rebalancing inherent in all such strategies. Efficient factor tilts explain none of the outperformance.

TOPICS: Factors, risk premia, factor-based models, performance measurement

Key Findings

• • The article confirms past results that fundamental indexes outperform the market-cap-weighted index.

• • Importantly, the article shows that all outperformance is due to the diversification return of Fernholz and Shay and Booth and Fama.

• • Standard explanations for outperformance (factor tilts) do not appear to hold up in factor models after accounting for the diversification return.