Credit: Shutterstock photoBy Shundrawn A. Thomas
The smart beta is actually an umbrella term for investment strategies that utilize alternative methods to construct indexes as opposed to traditional market capitalization weighting. Smart beta emphasizes various investment factors or characteristics in a rules-based and transparent way. Such strategies are often called multifactor investing.
The smart beta concept can be traced back to academic research, specifically the capital asset pricing model created by Bill Sharpe in the 1960’s. Sharpe turned the algebraic equation for a straight line into a market changing theory. His research determined that sensitivity to market volatility in a given security or portfolio, which he labeled beta, explained 70% to 75% of investors’ returns. Alpha, often considered the active return on an investment, gauges the performance of an investment against a market index used as a benchmark, since they are often considered to represent the market’s movement as a whole. The excess return of a fund relative to the return of a benchmark’s index is the fund's alpha. Sharpe posited that the other 25% to 30% were considered alpha.[i]
Expounding on Sharpe’s research, Eugene Fama and Ken French’s seminal work in 1992[ii] found that, while beta was the most explanatory factor, size and value were also important in illuminating portfolio performance. They determined that the level of exposure to value and small capitalization stocks, alongside beta, explained 90% or more of returns, leading to the identification of value and small cap as compensated risk factors. Later in the 1990’s Mark Carhart’s research added a fourth factor[iii], momentum. His research found that when momentum was combined with beta, value and capitalization, at least 95% of returns were explainable.
Today, smart beta strategists apply various multifactor approaches not to explain returns, but rather in an effort to get incremental returns into the portfolio and outperform a market-weighted portfolio over the long term.
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[i] Sharpe, William, 1964, “Capital Asset Prices: A Theory of Market Equilibrium under Conditions of Risk,” Journal of Finance, Vol. 47 (2), pp. 427-465.
[ii] Fama, E.F. and French, K.R., 1992, “The Cross-Section of Expected Stock Returns,” Journal of Finance, 22(1), pp. 3–26.
[iii] Carhart, Mark, 1997, “On Persistence in Mutual Fund Performance,” Journal of Finance, 52(1), pp. 57-82.
This article was originally published on IRIS.xyz.
Shundrawn A. Thomas serves as Executive Vice President, Head of Funds and Managed Accounts Group. He principally oversees the development, management and distribution of Northern Funds, Northern Institutional Funds and FlexShares Exchange Traded Funds as well as related business activities. His broad executive responsibilities involve developing long-term strategy, executing operating plans, managing client and vendor relationships and developing and retaining talented professionals.
Previously, Shundrawn served as President and Chief Executive of Northern Trust Securities, Inc., a wholly owned subsidiary of Northern Trust Corporation. In addition to his general management responsibilities, he was responsible for overseeing financial management and working with regulators including FINRA and the Securities and Exchange Commission. He also served as Head of Corporate Strategy for Northern Trust Corporation. As a direct report to the Chief Executive Officer, he supported executive management with key strategic planning initiatives. Prior to joining Northern Trust, Shundrawn served as a vice president for Goldman Sachs and held positions in sales, trading and research with Morgan Stanley.
Shundrawn received a BS degree in accounting from Florida A&M University and an MBA degree from the University of Chicago Booth School of Business. He has also completed executive education programs in corporate strategy at Chicago Booth School of Business and corporate governance at University of Notre Dame Mendoza School of Business. Shundrawn currently holds FINRA series 7, 63 and 24 securities licenses.
Shundrawn currently serves as a trustee for Wheaton College and as a board director of the Florida A&M University Foundation. Shundrawn is a member of the Economic Club of Chicago. His civic involvement has afforded him the opportunity to speak and lecture nationally on topics including leadership, strategy, investment management and professional development. Learn more here .
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.
