We couldn’t agree with some of the commentary from this article in Financial Advisor Magazine. Its why we created SmartStops.
The broader message is that indexing is moving past the standard beta carve-ups, such as small- vs. large-cap equities and value vs. growth stocks. A new era of factor-based indexing is dawning… Among the catalysts for the new indices is the growing use of factor models, says Rolf Agather, director of index research at Russell. “As investors become more sophisticated, they’re using risk factor models to have a better understanding of their risk exposures.” Elevating risk management to a high priority, in other words, is the new new thing. “Many investors are realizing that using a traditional framework built around countries, sectors or styles doesn’t always provide the insights for appropriately managing risk,” he explained in an e-mail. “Investors are looking for new ways to manage their risks more directly.”
Beyond One Beta
A key motivation for targeting multiple risk factors in portfolio design is recognizing the limits of using just one.
The broad market beta does the heavy lifting for explaining the link between risk and return, according to the capital asset pricing model (CAPM). (CAPM is Robert Merton’s invention) . But if CAPM worked as promised, one beta would suffice for explaining risk and return. More exposure to market beta would bring higher return; less exposure would mean lower return.
CAPM’s embedded message: Don’t waste your time with factors other than market beta. It’s an elegant story, and it simplifies portfolio design and management—if it works. But it doesn’t, at least not completely
Even if you have the stomach for sitting tight over ten or 20 years, the risk and return story isn’t as simple as CAPM suggests. Decades of empirical research show that there are other risk factors beyond market beta driving performance. In fact, the risk-return story is teeming with factor narratives. The concept of one dominant beta isn’t dead, but it’s no longer alone.