Our good friends at Redburn alerted us to the fact that the S&P 500 Equal weighted index made a new all time closing high this week, which we thought made a good occasion to revisit the relationship between the Equal Weighted and the Market Cap weighted S&P500. as shown in this long term Chart.
Chart 1: Market Cap v Equal Weight – No stock picking skills required!
We can see from this that for a period of almost 15 years after the Dot Com crash, stock picking was not needed to deliver so called ‘alpha’. The only thing you needed to ‘Outperform the index’ was simply to have exactly the same stocks but held at an equal weighting rather than the market cap based approach of the benchmark – so long as your management and marketing department let you ride out the occasional short term reversal along the way. This was the ‘dirty little secret’ of many so called active funds – they achieved their diversification by picking the big stocks in the benchmark, but then held them equal weighted rather than according to the distorted weights that had emerged during the dot com bubble. As we have noted on many occasions, what was the rationale behind having 10x as much in Cisco in 1999/2000 as you had in Berkshire Hathaway other than the Index told you this was (somehow) less risky? We are reminded here of Isiah Berlin’s Hedghog and the Fox, where this simple equal-weight strategy was the ‘one big thing’ that one needed to know as a hedge(hog) fund. No need to pretend we were canny foxes knowing many things about many companies, indeed, in extremis we didn’t need any stock picking skills whatsoever, we could own all 500 S&P stocks, just equally and yet charge for our ‘alpha’.
This gave birth to what became known as Smart Beta strategies, where all manner of strategies were sold by Investment Management Companies as having the ability to deliver excess return or ‘alpha’ compared to a market cap weighted index but where in fact the main strategy was: Step 1.Don’t market cap weight. Step 2. Do anything else to set weightings and call it smart Beta. Step 3. Charge for outperformance. Although nobody actually did have an index composed of stocks beginning with the first 3 letters of the Alphabet this would likely have outperformed as well! Indeed, valid criticism at the time of a lot of these strategies was that if we turned them upside down, i.e if we picked the inverse of a fundamental weighted index or a minimum volatility index or a minimum variance weighted index (to pick three of the most popular Smart Beta styles) then these also ‘delivered alpha’!
Of course what these non market cap weighted indices were really all demonstrating was a tilt to small(er) cap and value stocks and a lot of work was put in around 2010-2014 as to how to develop robust proxies to capture these premia. For those interested, this is a good research discussion from EDHEC about the subject at the time.
Valid work on Smart Beta has got rather overlooked in the last few years as Market Cap appeared to dominate again
For much of the last decade however, this hasn’t really worked as a strategy, mainly due to the growth and dominance of big Tech and the evolution of QE which favoured the very biggest companies over smaller ones. Indeed over the last 5 years this simple approach to Smart Beta has actively worked against you. Until now perhaps, that is. If we look at Chart 2, which is a zoomed-in version of Chart 1, focussing just on the last 5 years, we can see that 2020 looked like something of a ‘blow off top’ for mega caps outperforming more normal sized large cap companies and that part of what we might think of as value versus momentum or cyclicals versus growth may very well just be this mega cap effect unwinding.
Chart 2: Are we entering another Smart Beta cycle?
There have been exceptions of course, most notably in some of the Thematic funds focussed on areas like Robotics, automation and Technology, making thematic investing one of the main drivers of active investing, (full disclosure we did a lot of this in my time with Axa Investment Managers). Indeed these areas dominate the newly emerging Active ETF space – currently dominated by ARK Investments, which come with their own problems (see previous discussions such as this one on illiquidity).
The other big area of Smart Beta success has of course been ESG, which is indeed a form of Smart Beta strategy, as it doesn’t market cap weight since it excludes some of the larger companies in the Oil and Gas space – although since it usually replaces them with mega cap Tech stocks it has benefited from this poor environment for smart Beta generally. This also raises some interesting questions of how active an ESG strategy should be. Is it an active strategy seeking to allocate institutional capital where it can ‘make a difference’ or is it simply a case of charging to track a different benchmark, that thanks to its design, has so far ‘out-performed’ the benchmark the Asset Management Companies are asking you to compare it with? The risk for ESG managers of course is that, as with other smart beta strategies from a decade ago, the clients ask that they benchmark themselves against the appropriate benchmark rather than pay active management fees for a passive investment approach. ESG is currently the great white hope of many Investment Management CEOs, but the ability to withstand fee compression for what in many cases is simply another passive index product is likely to be minimal.
Diversification is desirable, but portfolio construction that simply mimics the market cap weighting of an index is sub-optimal. QE has distorted all financial markets and has been partly responsible for distracting the investment management business from these facts, but as we shift to a fiscal rather than a monetary environment, this too will change we think. Active ETF strategies offering active smart Beta products look to have a better chance to succeed, not least as individual savings rather than institutional investment are increasing, especially in Asia, and we suspect that the research literature in this area as well as the product offerings will start to increase. Smart Beta is back.
