CALLAN

INVESTMENTS
INSTITUTE

September 2015

Research
Spotlight

The Education of BetaRevisited

A year ago we published The Education of Beta: Can Alternative Indices Make Your Portfolio Smarter? by
Eugene Podkaminer, which was recently republished in The Journal of Investing. With smart beta still in
the news and on investors minds, we wanted to highlight some of the papers main points and encourage
interested readers to take a deeper dive by reading the full article.
Insights include:
Alternatives to traditional cap-weighted indices have been growing in popularity as investors strive to
add diversification using a transparent, mechanical, and low-cost approach.
Alternative index strategies, sometimes called smart beta, promise enhanced return, often with lower
risk and greater diversification power. We examine a number of such strategies and find that many
feature persistent tilts (especially to value and small cap stocks) that account for the majority of their
risk and return characteristics.
Because smart beta strategies reweight stocks from the same universe, diversification with standard
benchmarks has typically been weak.
Investors who embrace factor tilts may consider risk premia approaches that are multi-asset class
and long/short.

Gene is a frequent

Investors who are skeptical of active management

speaker on risk factors

can use alternative indices to extend a passive core.

and smart beta; he has

over 15 years of experience designing multiasset class solutions.

On the other hand, investors who believe in the value

of active management can use alternative indices to
obtain low-cost, semi-passive exposure. Regardless
of your perspective, the availability of a middle
ground option enables greater control in constructing
portfolios of managers when implementing a strategic
asset allocation.
Gene Podkaminer, CFA, Senior Vice President, Capital Markets Research

Knowledge. Experience. Integrity.

Before truly passive index tracking portfolios were developed in the 1970s, the total returns of active
strategies were treated entirely as manager skill, or alpha. The Capital Asset Pricing Model (CAPM)
and Arbitrage Pricing Theory demonstrated that part of that manager skill was actually systematic
exposure to markets, or tilts. Fama, French, Carhart, and others popularized the value, size, and
momentum factors in the 1990s. Today we use a more granular approach than simply market beta to
specify a tilt or factor, and alternative indexing can replicate those tilts for us (Exhibit 1). 

Exhibit 1

Cap-Weighted Index

Alternative Index

Traditional Active

The Evolution of Alpha

and Beta

Factor
Tilts

Factor
Tilts

Simple CAPM framework aggregates persistent factor tilts

and alpha into the alpha term.

Alternative indexing allows you

to reproduce persistent factor
tilts cheaply and reliably.
Source: Callan

Building any index requires three crucial decisions. First, define the investable universe, which may
be emerging market small cap stocks or U.S. large growth stocks. Then, figure out how to arrange
those securities, whether by capitalization, equal or GDP weights, minimum variance, or fundamental
characteristics. Finally, specify constraints (e.g., maximum position sizes or liquidity parameters).
Exhibit 2 presents a hierarchy for index construction and separates the weighting decision into three
components. For example, the Russell 3000 Indexs investable universe is all U.S. common stock;
those stocks are assembled based on cap weights, and a few constraints are applied. We find that
smart beta strategies differ from traditional indices on all three levels, and that a smart beta strategy
can be created based on changing just one or two of these decisions.

Exhibit 2
Build an Index in
Three Easy Steps

1
2

Universe Selection
Weighting Scheme

Risk-Aware

Equally Weighted
Securities

Minimum/Low
Volatility/Variance

Fundamental Factors

Equally Weighted
Countries

Risk Weighted

Value

Equally Weighted
Regions

Maximum Sharpe Ratio

Quality

(Maximum Diversification)

Maximum
Deconcentration

Momentum

GDP Weighting

Maximum Decorrelation

Dividend Yield

Equal Risk Contribution

Simple Reweighting

Return-Aware

Constraints

Source: Callan

Related Research: Risk Factors

Gene has also written extensively about risk factors (see Risk Factors as Building Blocks for Portfolio
Diversification: The Chemistry of Asset Allocation, CFA Institute Investment Risk and Performance, January 2013). In this article, Gene explores portfolio construction using risk factors as the basic elements.
Theoretically, this approach may result in lower correlations among various portfolio components and may
lead to more efficient and diversified allocations than traditional methods. However, the practical limitations of
policy portfolios constructed with risk factors are significant enough that few investors are currently embracing
full-scale implementation.
To learn more, read The Education of Beta: Can
Alternative Indexes Make Your Portfolio Smarter? in
the Summer 2015 issue of The Journal of Investing.

For Further Reading

Risk Factors as Building Blocks for
Portfolio Diversification: The Chemistry
of Asset Allocation CFA Institute
Robustness of Smart Beta Strategies
The Journal of Index Investing
Smart Beta: The Owners Manual
The Journal of Portfolio Management

Knowledge. Experience. Integrity.

If you have any questions or comments, please email institute@callan.com.

About Callan Associates
Callan was founded as an employee-owned investment consulting firm in 1973. Ever since, we have
empowered institutional clients with creative, customized investment solutions that are uniquely backed
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investment managers, and financial intermediaries. For more information, please visit www.callan.com.
About the Callan Investments Institute
The Callan Investments Institute, established in 1980, is a source of continuing education for those in
the institutional investment community. The Institute conducts conferences and workshops and provides
published research, surveys, and newsletters. The Institute strives to present the most timely and relevant
research and education available so our clients and our associates stay abreast of important trends in the
investments industry.
2015 Callan Associates Inc.
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