A recent article in CFA Institute suggests ways to combine alpha and beta factor strategies to create a “simple and clean equity portfolio” that offsets some of the “innate human weaknesses that sabotage our investment decisions.”
According to the article, factor investing has generated positive excess returns—alpha—over time. Specifically, between 1926 and 2019, “a portfolio that combines small, cheap, and outperforming stocks” would have outpaced the broader market (data from Kenneth French) while one comprised of “large, expensive and underperforming stocks” would not.
That article argues, “we can build the difference between these two strategies through a long-short portfolio with exposures to the Size, Value and Momentum factors:”
“Instead of structuring an equity portfolio as smart beta by selecting stocks ranked by factors,” the article explains, “we could allocate to a combination of the stock market and a long-short multi-factor portfolio. We could build an alpha + beta strategy through ETFs or liquid alternative mutual funds” for costs comparative to those of smart beta ETFs.
According to the article, the advantages of combining both alpha and beta strategies include:
- A smart beta portfolio “lacks clarity and requires continuous performance attribution analysis to differentiate between beta and factor returns.”
- “Allocating to a long-short multi-factor portfolio results in returns more in line with those in factor investing’s foundational academic research.”
- Noting that smart beta ETFs have stock market correlation of over 0.9, the article suggests that alpha could serve as a bond proxy in a balanced portfolio. “In a low interest rate environment,” it adds, “this is an intriguing point.”
The following chart illustrates historical risk-return ratios for both alpha + beta portfolios compared with smart beta or plain beta:
The article concludes, “Factor investing’s adherents have volumes of academic research to support their approach. Plenty of products provide direct exposure to long–short factors with transparent methodologies, daily liquidity, and low fees. Through them, investors can build simple and clean equity portfolios composed of beta and alpha that should deliver superior risk-adjusted returns.”