Essentially, smart beta strategies employ alternative weighting methodologies, as opposed to market-cap weighting, to achieve a better risk/reward outcome. Smart beta approaches may be single-factor based (e.g. revenue, dividends, volatility, momentum, etc.) or multi-factor (a combination of single factors). There are a multitude of approaches and products designed around them. Smart beta products based on fundamental indicators such as revenue, earnings or dividends have been gaining in popularity recently as the markets have reached lofty valuations.
In this issue, we will focus on revenue-weighted smart beta. As the name implies, this approach entails creating portfolios that are weighted according to the top-line revenues of the companies in a given index. As an example, the S & P Index is shown below under two scenarios as of June 30th : market-cap and revenue-weighted bases. One can see the clear difference in composition based on the differing methodologies.
Using a review-weighted smart beta strategy has certain advantages as listed below. However, it is important to keep in mind that this is only one methodology and by no means the only approach that can work.
- Provides diversified coverage, but emphasizes a company fundamental metric (revenue) versus stock price. Empirically, the revenue variable has been shown to have a higher correlation to long-term performance than many other factors
- Using revenue weighting moves portfolio composition away from a focus on overvalued momentum stocks toward lower valuation companies which historically have generated excess returns over time
- Allows the reduction in portfolio risk via targeted exposures as well as more stability through various market cycles
- Can result in benchmark index outperformance without the recent underperformance and higher fees associated with active manager strategies
As with most smart beta strategies, this approach has been financially engineered through the use of ETFs. There are various offerings from firms such as Oppenheimer, Vanguard and others. The data shown below uses a particular Oppenheimer ETF and is used solely for illustrative purposes. As always, please review several alternatives before making any investment decisions or recommendations.
The context for the graph and data above is to simply point out this approach as a possible alternative to the S & P 500. Significant, long-term outperformance is not the intention. As mentioned, the revenue-weighted approach (Oppenheimer Large Cap Revenue ETF Total Return – RWL) provides for opportunities to hedge periods of market overvaluations/frothiness wherein mean reversion can be a heightened risk in a market cap-weighted portfolio (e.g. 2015). The referenced fund is the line in orange.
For a further comparison of RWL against the S&P 500 over a 5 year basis see below.