CNNMoney sums the idea up nicely:
The goal of smart beta is to boost returns by using a "rules based" approach that puts more weight on other factors, such as valuations, dividends, momentum or volatility to determine which companies to own and how much of their stock to buy.
But weighting by other metrics seems just as arbitrary as weighting by market cap. There are reasons different companies have difference valuation metrics and there's no guarantee that dividend growth or high dividend-paying companies will always beat the market. Momentum and volatility seem even more arbitrary. Low volatility stocks have their benefits, but in the long stretches, higher volatility small cap equities will do better. Many of these strategies might look pretty based on some convenient back-tested data and are used to justify higher expense ratios than pure passive index ETFs. But I suspect smart beta will end up succeeding about as much as most other active strategies before them: not very well over time.
But I digress. From what I can tell, there is one metric that consistently predicts over and under-performance relative to the market: size. And by that I mean the outliers in the market. Yes, the biggest public companies is the U.S. make up most of the market's value, but ultimately they're the biggest of the big. It's a legitimate question to ask if it makes sense to have most of your investment tied up in the extreme end of one spectrum of the market. And when you hold the market portfolio or something similar, like the S&P 500, most of your eggs are in mega (or giant) cap stocks.
On the other end, we have another extreme: micro caps. These little guys have a whole different set of problems of their own. They're so tiny, they're often difficult to invest in (low liquidity, huge bid/ask spreads) and it's a challenge finding an ETF that accurately mimics existing micro cap indexes. In theory they may have great long-term returns, but it's just a theory because there are many challenges to owning them.
To test this hypothesis, let's look at the Kenneth French data on portfolios formed on size (including dividends). I can't emphasize enough how useful and valuable this data is (from CRSP - The Center for Research in Security Prices). The data is broken split out three ways: 30/40/30, quintiles, and deciles. We'll just look at deciles since the top 10% of companies by market cap is the best representation of mega caps (currently consisting of about 161 stocks, so a bit more than the S&P 100).
There are endless ways to slice-and-dice this data, but I thought it would be useful to look at average annual returns for each decile by decade. I highlighted the deciles that performed above and below average during each time period (including to partial decades at the end of the 1920s and the current decade):
A few things jump out at me. First, in general, the largest three deciles have consistently been among the worst performers decade-after-decade, with the largest decile most often being the worst.
Second, the smallest deciles exhibit some consistency with performing above average, indicating the small cap premium is consistent and real. Lastly, the smallest decile, while it's had bad stretched of performance, has often outperformed everything else by a wide margin. But we know investing in these stocks difficult (if not impossible) in practice.
What market caps generally correspond with each decile? In the first box below, you can see the top decile consists of companies averaging about $83 billion in size - mega cap territory. As we mentioned above, mid caps (specifically the S&P 400) fall roughly closer to the $5 billionish range, so probably map closer to deciles 6-8. Some of the biggest holdings in the Russell 2000 cross into mid cap territory, but the weighted average is closer to $1.7 billion. Deciles 3-5 are probably most indicative of that index. The smallest decile would firmly fall into a micro cap categorization, and I suspect we could classify some of the 2nd decile stocks the same way (and many likely have liquidity issues).
Over shorter 30, 20, and 10-year time spans, the small and mid cap range of the market has also been the place to be. While most agree small caps have overheated during recent years, a major correction would be required and/or a large run-up in large and mega caps to narrow the gap.
Draw your own conclusions from this data, but from my perspective there is ample evidence to suggest:
- The size premium is real (or at least more convincing than the value premium) and appears to hold true for stocks in the more liquid small and mid cap range.
- Mega caps might be too big - they may weigh down long-term returns.