Romedius Troberg. Smart Beta. Alternative Concepts in Passive Portfolio Management. Anchor Academic Publishing. disseminate knowledge

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1 Romedius Troberg Smart Beta Alternative Concepts in Passive Portfolio Management Anchor Academic Publishing disseminate knowledge

2 Troberg, Romedius: Smart Beta: Alternative Concepts in Passive Portfolio Management, Hamburg, Anchor Academic Publishing 2015 PDF-eBook-ISBN: Druck/Herstellung: Anchor Academic Publishing, Hamburg, 2015 Additionally: Leopold-Franzens-Universität Innsbruck, Innsbruck, Deutschland, Master Thesis, 2014 Bibliografische Information der Deutschen Nationalbibliothek: Die Deutsche Nationalbibliothek verzeichnet diese Publikation in der Deutschen Nationalbibliografie; detaillierte bibliografische Daten sind im Internet über abrufbar. Bibliographical Information of the German National Library: The German National Library lists this publication in the German National Bibliography. Detailed bibliographic data can be found at: All rights reserved. This publication may not be reproduced, stored in a retrieval system or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without the prior permission of the publishers. Das Werk einschließlich aller seiner Teile ist urheberrechtlich geschützt. Jede Verwertung außerhalb der Grenzen des Urheberrechtsgesetzes ist ohne Zustimmung des Verlages unzulässig und strafbar. Dies gilt insbesondere für Vervielfältigungen, Übersetzungen, Mikroverfilmungen und die Einspeicherung und Bearbeitung in elektronischen Systemen. Die Wiedergabe von Gebrauchsnamen, Handelsnamen, Warenbezeichnungen usw. in diesem Werk berechtigt auch ohne besondere Kennzeichnung nicht zu der Annahme, dass solche Namen im Sinne der Warenzeichen- und Markenschutz-Gesetzgebung als frei zu betrachten wären und daher von jedermann benutzt werden dürften. Die Informationen in diesem Werk wurden mit Sorgfalt erarbeitet. Dennoch können Fehler nicht vollständig ausgeschlossen werden und die Diplomica Verlag GmbH, die Autoren oder Übersetzer übernehmen keine juristische Verantwortung oder irgendeine Haftung für evtl. verbliebene fehlerhafte Angaben und deren Folgen. Alle Rechte vorbehalten Anchor Academic Publishing, Imprint der Diplomica Verlag GmbH Hermannstal 119k, Hamburg Hamburg 2015 Printed in Germany

3 Table of Contents List of Figures... 1 List of Tables... 2 List of Abbreviations... 3 Introduction Why new concepts like Smart Beta? Traditional Concepts Active Fund Management and the Alpha Passive Fund Management and the Beta Market Capitalization Weights (CW) Smart Beta Concepts Fundamental Weights (FW) Style Indices Max. Deconcentration (MD)/Equal Weighting (EW) Diversity Weights (DW) Most Diversified Portfolio (MDP) Global Minimum Variance (GMV) Risk Parity (RP) also known as Equal Risk Contribution (ERC) Maximum Sharpe Ratio (MSR) Existing Indices Practical Part Development of new indices Idea Stock selection Fundamental Data Return Volatility Sharpe Ratio ADTV Effective number of stocks Backtest Equally Weighted Portfolio Equal Risk Weighted Portfolio Most Diversified Portfolio Out of Sample Minimum Variance Portfolio Out of Sample constrained Minimum Variance Portfolio Out of Sample Maximum Sharpe Ratio Portfolio Out of Sample constrained Maximum Sharpe Ratio Portfolio Conclusion List of References Appendix

4 List of Figures Figure 1: Markowitz efficient frontier Figure 2: Minimum Variance Portfolio vs. Maximum Sharpe Ratio Portfolio according to Markowitz (1952) Figure 3: Performance MSCI World Equal Weighted vs. MSCI World 33 Figure 4: Weights for the 30 DAX constituents, according to Deutsche Börse (2013a)...36 Figure 5: Equally Weighted Portfolio Figure 6: Equal Risk Portfolio Figure 7: Maximum Diversified Portfolio Figure 8: Minimum Variance Portfolio.. 47 Figure 9: Minimum Variance Portfolio constrained Figure 10: Maximum Sharpe Ratio Figure 12: Maximum Sharpe Ratio constrained

5 List of Tables Table 1: Illustration of the meaning of beta Table 2: Return Characteristics of Alternative Indexing Metrics Table 3: Liquidity Characteristics of Alternative Indexing Metrics Table 4: Example for different percentages of the diversification weights Table 5: An overview of stock selection and weighting decisions of some alternative equity indices. 32 Table 6: Risk and Return Characteristics of the MSCI World Index and the MSCI World Equal Weighted Index Table 7 Financial Ratios Equally Weighted Portfolio vs. DAX Table 8 Financial Ratios Equal Risk Weighted Portfolio vs. DAX Table 9 Financial Ratios Most Diversified Portfolio vs. DAX Table 10 Financial Ratios Out of Sample Minimum Variance Portfolio vs. DAX Table 11 Financial Ratios Out of Sample constrained Minimum Variance Portfolio vs. DAX Table 12 Financial Ratios Out of Sample Maximum Sharpe Ratio vs. DAX Table 13 Financial Ratios Out of Sample constrained Maximum Sharpe Ratio vs. DAX 54 2

6 List of Abbreviations ALLORDS BLUE CAP CAPM CR DAX DR DW ERC ETF EW FTA FTSE FW GMV MCW MD MDP MPT MSCI MSR OLS p.a. RAFI RP SD S&P s.t. TE TOPIX VAR = All Ordinary Index = Best Linear Unbiased Estimator = Capitalization = Capital Asset Pricing Model = Concentration Ratio = Deutscher Aktien Index = Diversification Ratio = Diversity Weights = Equal Risk Contribution = Exchange Traded Fund = Equal Weighting = Financial Times Actuaries = Financial Times Stock Exchange = Fundamental Weights = Global Minimum Variance = Market Capitalization Weights = Maximum Deconcentration = Most Diversified Portfolio = Modern Portfolio Theory = Morgan Stanley Capital International = Maximum Sharpe Ratio = Ordinary Least Squares = per annum/per year = Research Affiliates Fundamental Index = Risk Parity = Standard Deviation = Standard and Poor s = subject to = Tracking Error = Tokyo Stock Price Index = Variance 3

7 Introduction Why new concepts like Smart Beta? In economics, each and every rational decision made is supposed to maximize individual utility. This approach especially applies to the investor in financial goods. In accordance with neoclassical utility optimization, the individual investors are supposed to be willing to exchange investment good in order to maximize their expected future return. This approach anticipates every individual investor to try and estimate the future cash flows of the investment in order to evaluate its current value. Hence, trades at every stock exchange are to be executed at all times where you have two investors differing in their estimation of the intrinsic value of an investment product. As soon as one investor holds some asset that has a higher market price than he/she estimated the value of the asset to be, he/she is then supposed to want to sell this asset instantly. On the other hand, in the case of an investor expecting an asset to be undervalued, he/she should try to invest in that asset. As a consequence, every investor is supposed to create a portfolio with assets that in turn maximize his/her expected return. Every investor is supposed to make an individual and rational attempt to maximize his/her utility and to behave in a risk-averse manner. That means that every investor is supposed to choose the respective investment asset that shows a lower risk with the same expected return or show a higher expected return with the same risk. All information that may have an influence on the valuation of the asset is to be observed at the same time by every individual investor and taken into consideration at the same time. As every shred of information is evaluated in its own individual way, the individual estimate of the current value of an asset should differ for each and every investor. However, according to the neoclassical theory, it is not possible to gain more from an investment than the market does, as long as markets are efficient. Financial markets can be seen as the most efficient markets, if not the only efficient markets in real economy, as, in the market context, information is transferred the fastest and prices are thus adopted nearly instantly. Nevertheless, all investors at the stock exchanges try to make money by using their individual knowledge in order to gain something from investing in some assets. They have of course, at the same time, the possibility to follow the market themselves or to try to bet against the market. Every investor hence always faces the question of whether to trade on the market with his/her own individual knowledge in order to gain some additional utility, or to simply attempt to do the same as the whole market and follow the belief of the market at a whole. The question thus arises of what exactly efficient fund management looks like. This paper will discuss several possibilities which arise in literature and in the real economy when thinking about fund management, and will 4

8 discuss the rather new concept of Smart Beta investments, in particular. The focus of this paper thus lies in the question of whether smart beta concepts serve as potential superior alternatives to the classical passive investment products. 5