Alpha and beta.
A basic premise of the efficient markets hypothesis is that you shouldn’t be able to beat the market in simple dumb ways. (Stronger forms say you shouldn’t be able to beat it in difficult smart ways either, but leave that aside.) So buying stocks with relatively low prices, or low volatility, or good recent past performance, or that start with the letter R, or that have green logos, or buying on Monday and selling on Thursday, shouldn’t get you returns that are better than a broad market index. But sometimes that stuff works anyway, and so there are "smart beta" funds that try to beat the market in simple dumb ways (sometimes with math, but still): They don’t do much active trading or subjective stock-picking, but they do overweight stocks with relatively low prices, or low volatility, or good recent past performance, or whatever, because stocks with those factors have generally outperformed the overall market.
Why does this work? There are about three possibilities. (Here I am loosely following Cliff Asness .)
> Perhaps the outperformance of, say, stocks starting with the letter R is compensating investors for some extra risk: Those stocks have some risk in addition to regular market risk, and so investors demand higher returns for holding them.
Perhaps there is some persistent human behavorial bias that affects prices: People are always gloomy on Mondays and happy on Thursdays, so stocks are cheap on Monday and expensive on Thursday.
Or maybe it doesn’t work at all, it is all an illusion in the data, and as soon as you mention the outperformance of stocks with green logos it will stop.
Anyway, at the Financial Times, John Authers is skeptical of smart beta, arguing both for theory 1 (the outperformance compensates for risk) and theory […]
