Describe the underlying principle of a smart beta strategy
What will be an ideal response?
In contrast to traditional bond portfolio strategies that seek to replicate or outperform the risk premia embedded in a bond market index, smart beta strategies has an underlying principal that seeks to capture a wider spread of risk premia by means of a low-cost investment process. Smart beta strategies strive to do so byproviding better diversification benefits than traditional bond portfolio strategies that have as their benchmark a market-cap-weighted bond index. More details are given below.
The underlying assumptions of proponents of a smart beta strategy are (1) market-cap-weighted bond indexes are flawed, (2) the implementation of active strategies versus a market-cap-weighted indexes comes with high fees, (3) in the long run active strategies will underperform a market-cap-weighted index, and (4) there are strategies between passive (beta) strategies and active (alpha) strategies that can more effectively capture on a cost-effective basis the risk premia in the bond market.
The building block for smart beta strategies is the identification of systematic risk drivers of bond returns. Smart beta strategies involve the construction of an index as the benchmark. The index, referred to a "smart beta," is expected to offer a better risk-return profile than a market-cap-weighted bond index described earlier in this chapter. Purveyors of smart beta strategies will back-test the strategy to provide support for the superior profile relative to market-cap-weighted bond indexes. Before any smart beta strategy is adopted, it is imperative that the back-testing period be of sufficient length under a range of market and economic conditions.
In formulating a smart beta strategy, there are two weighting schemes used in practice: heuristic-based weighting and optimization-based weighting. The simplest one is heuristic-based weighting strategies. These strategies use one of the weighting schemes described earlier in this chapter such as equal weighting or fundamental weighting. The more complex strategy is the one based on optimization-based weighting where a smart beta is sought that has a minimum variance or maximum diversification. Optimization-based weighting strategies are more commonly used in the equity area than the bond area.
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