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An Unexpected Reason Behind This Strategy’s Outperformance

markus_mainka / Shutterstock
markus_mainka / Shutterstock

One of the great anomalies of investing: The historical long-term outperformance of certain smart beta or factor-based strategies relative to the broader equity market (think choosing stocks based on their valuations, momentum, low volatility or quality metrics such as profitability ). For example, according to data from MSCI, the MSCI USA Minimum Volatility ( USD ) index's Sharpe ratio , a common way to measure risk-adjusted returns, was 0.61 for the last ten years, above the benchmark MSCI USA Index's 0.44 ratio. The persistence of smart beta strategies' outperformance relative to the broader market is surprising because it doesn't line up with the idea of an efficient market, one in which investors shouldn't be able to simultaneously buy and sell securities for a profit without taking extra risk ( the so-called "no arbitrage" principle ). In other words, in an efficient market, equity portfolios exhibiting low volatility, for instance, shouldn't be able to earn comparable returns to their higher risk counterparts. It's no wonder, then, that numerous academic and financial industry research papers have been written on this topic, and there are various explanations for factor strategies' outperformance. According to BlackRock's smart beta experts, including Blog contributor Sara Shores , this outperformance can generally be attributed to a risk premium, structural impediment or behavioral anomaly. In other words, the outperformance is to compensate investors for taking on what's actually a higher level of risk, a reflection of market supply-and-demand dynamics or the result of common decision-making biases.

The human factor

Value

Value stocks procyclical people's tendency to look at recent data trends and believe those trends will continue loss aversion can help explain this anomaly

Momentum

momentum leading to slow dissemination of firm-specific information the anchoring-and-adjustment heuristic herding effect

Quality

can effectively be characterized as having less risk based on their fundamentals

Low volatility

people's tendency to overestimate small, and underestimate, large probabilities

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.


The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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