Case Studies

Smart(er) Beta and a New Tactical Index

July 26, 2014
Recently there has been considerable focus on smart beta or fundamental factor weighted indexing.     

Smart beta indexes are transparent, rules-based indexes designed to provide focused exposure to specific factors, market segments or investment strategies. Typically not weighted by market capitalization, smart beta indexes provide unique opportunities for investors to increase portfolio diversification, reduce risk and enhance returns over time.

Supporters have been quick to point out that that they have outperformed the S&P 500 for the past 5 years.

Where Active and Passive Meet

At the core of these strategies is a transparent, rules-based design that provides focused exposure to specific factors, say for instance dividends or revenue.

Academic research on many of these strategies has found that they have historically delivered excess returns and improved risk-adjusted returns over long time periods, and so they are called “smart.”  But as should be pointed out, styles and factors drift in and out of favor, so it’s important to realize that “smart” strategies will have periods of underperformance when compared to a benchmark.  It is often this point that strategist who speak against smart beta, cite.

To my knowledge, most of the these new indexes are based upon preset fundamental factors.  But what if we instead used an adaptive strategy that again was rules-based, but also shifted as styles and asset-classes moved in and out of favor?  Would not that be, umm…smarter?   This would also overcome my own personal objection that smart beta will not be sufficient to protect investors during the next bear market.  (Yes, I still believe in them).   Smart or not, when the ships starts to sink…everyone aboard is going down.  Thanks, but I want my strategy to have a lifeboat.

There are a number of index-based financial products, most of them tied to a passive indices such as the S&P 500, the DJIA, FTSE 100, or the Hang Seng Index.  Less common are index products linked to a formulaic index such as these newer smart beta strategies.  Personally, I think there is a ton of opportunity here.

Which is why I am pleased to announce that a new global and 100% formulaic index I developed is now live on Bloomberg.   This new index utilizes the same systematic, rules-based approach that I use to develop Portfolio Cafe models and combines the use of dual momentum, trend, and volatility analysis.

The index actively rotates between U.S. Equities, International Equities, Emerging Markets, Commodities, REITs, International Bonds, U.S. Treasuries, Corporate Bonds, High Yield, and Gold.   The index can be as much as 100% cash and bonds to as much as 60% equities depending upon market conditions.

While monthly rebalancing is the normal best practice, a new aspect to the construction is a “time diversification” element that is achieved by rotating a fixed percentage of the index every so many days – each held for a 28 day period.   The purpose of this is to capture emerging opportunities and to reduce the exposure to market changes that may occur shortly after a monthly rebalance with the goal of a very smooth equity curve.

This new index was designed to be the basis for several new financial products under various stages of development – more about these to come.

lifeboatThe index strategy has done a nice job of capturing upside while keeping risk low…and as is common among all of my strategies, the lifeboat is included as part of the package.

Summary Statistics

 CAGRSharpeCorrelation to SPXMaximum Drawdown
Index Strategy17.1%1.030.03-13.5%
S&P 5006.7%0.28-55.2%

Index Annual Performance

Index Strategy17.8%19.1%21.4%9.2%37.8%4.5%12.3%9.8%
S&P 5005.1%-36.8%26.4%15.1%1.9%16.0%32.3%8.0%
Index strategy performance for period 12/29/2006 to 07/25/2014




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