Smart Beta Is Not Monkey Business

Abstract

Monkey portfolio proponents argue that all smart beta strategies generate positive value and small-cap exposure, which fully explains their outperformance. They also claim that similar results are obtained by any random portfolio strategy, including the inverse of such strategies. We analyze these claims using test portfolios that follow commonly employed methodologies for explicit factor-tilted indexes. Our results directly invalidate the hypothesis that these claims hold for all smart beta strategies. In particular, our results show that, although some strategies such as fundamental equity indexation may perhaps mostly be driven by a value tilt and may generate similar performance to their upside-down counterpart, many smart beta strategies display exposure to additional factors, as well as pronounced differences in factor exposures across different strategies. Moreover, and perhaps reassuringly, the inverse of these strategies generates lower performance. That our findings directly contradict the monkey portfolio claims can be explained by our set of test portfolios. Although the monkey portfolio arguments may hold for the particular smart beta specifications tested by its proponents, they do not hold in general. An important implication of our results is that one should take care to avoid overgeneralizing tests of particular specifications of smart beta. For the explicit factor-tilted strategies tested here, our results imply that a careful assessment of investment philosophy and index design is indeed relevant as such strategies do not behave like monkey portfolios.