The outperformance of smart beta strategies over traditional capitalization-weighted index: focus on smart beta EFTS domiciled in the United States

Abstract

Capital market theories are based on relatively idealistic assumptions that are not met in the real life, such as the normality of the returns, the market efficiency, etc. Therefore, the traditional asset pricing model CAPM is largely criticized. Researchers have introduced alternative models that include additional risk factors and the value added of those models is acknowledged in the literature. Particularly, the extension of the models and the market environment (the global financial crisis in 2008) have pave the way for a new category of investment: Smart Beta. Smart Beta providers argue that this strategy can offer better returns, lower risks, and enhance diversification. However there is a huge marketing pressure behind the development of Smart Beta investments. Especially, the proportion of Smart Beta strategies under the form of exchange traded funds has exploded. The purpose of this thesis is to analyze the validity of the Capital Asset Pricing Model assumptions and the actual outperformance of the so-called Smart Beta strategies over the traditional capitalization-market S&P 500 over three different sample periods. Therefore, the normality of the returns is tested, time series regressions are performed based on the CAPM and on the four-factor model proposed by Fama, French and Carhart and performance measures are computed. The results confirm the supremacy of the four-factor model over the traditional CAPM and the non-normality of the returns. Nonetheless, additional risk factors could be added to the model for certain Smart Beta strategies. Regarding the outperformance of Smart Beta strategies, the outcome is mixed. They appear to achieve particularly good performance during the financial crisis in 2008-2010 compared to the S&P 500 index but this outperformance does not sustain in 2010-2016, except for one equally weighted strategy including large-cap and growth stocks. This confirms that dependence of Smart Beta strategies to the market environment. All Smart Beta strategies are not “smart”: some of them exhibit poor performance measures and persistent underperformance with respect to the S&P 500 index.