Speaking Greek

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Alpha, Beta, Sigma, Omega, smart-beta, classic-beta, adaptive-beta, dynamic-beta. Everywhere you look there seems to be a new and different flavor of Beta.  Is it active beta or passive beta?  Debates swirl and new trendy Greek words and symbols continue to creep up.  Having recently launched our Adaptive Wealth Strategies U.S. Factor Index, I’d like to share our opinions on and definitions of a few varieties of Beta.  Classic Beta, Smart Beta, Adaptive Beta, etc. all sound similar, yet the investment philosophies behind each are surprisingly different. 

Let’s first state the mathematical definition of Beta.  Beta is the slope variable in a linear regression, represented by b: Linear Regression: Y = a + bX + u.  In the case of investments, it is designed to measure the systematic risk, or overall market-risk, contained in a security.  In mathematical terms, it is the dependency of one variable on the change of another. 

Let’s drill down to what we call classic-beta.  Think of this as the market-cap weighted broad market indices.  The S&P 500 took its ‘current’ form in 1957 by utilizing the market capitalization method.  In today’s terms, it means holding almost four times the amount of Apple compared to Wells Fargo, simply because the market capitalization of Apple is four times larger than Wells Fargo.  Classic-beta means you choose to own the market, for better or worse, designed with the original math that was created in 1957. 

Smart-beta, which has garnered significant attention over the past several years, is unique and utilizes different approaches.  We think of smart-beta as simply using a different weighting mechanism than a market-cap weighted approach.  This could take the form of value weighting based on P/E, P/B, P/S.  It could also take the form of dividend weighting, D/P, or even momentum, based on trailing price returns.  It could also take the form of multi-factor products that equally weight different smart-beta mechanisms.  There are numerous ways to slice and weight the individual constituents that make up the overall market, and for now, the industry has labeled this as “smart-beta.”  While I’m sure not all the approaches currently available are truly “smart,” the computational power required to implement these different weighting schemes is certainly far superior to that built in 1957. 

This brings us to Adaptive-beta.  Market dynamics change over time, and the ability to adapt to these new environments is critical.  Having a static weighting to value, cap-weighting, or momentum can certainly perform well during certain periods of time, just as they can perform poorly during other periods of time.  Our adaptive-beta approach systematically changes exposures to three different factors with the goal of removing beta exposure to the segment or factor of the market that has become overly stretched to the upside.  Our adaptive factor index employs this dynamic allocation.  By having this adaptive approach, risk metrics should improve along with potential overall performance.  We think it makes sense, as markets change beta exposure should change as well.

Regardless of what naming mechanism is used, beta is simply the slope coefficient that illustrates how much market risk is in the security or portfolio.  The math will always remain the same.  Investors’ risk exposure, however is certainly different depending on which type of beta is implemented.  Knowing and understanding this exposure is crucial.  There will certainly be times where classic, market-cap weighted beta will perform well; the same with smart-beta.  Ultimately, having an adaptive approach is something we feel works better over the long-run.  This is one of the reasons why we developed our Adaptive Wealth Strategies U.S. Factor index.  So, while 1957 might be considered part of the Nifty Fifties, much has changed since then— especially computing power.  Shouldn’t your beta change as well?  We think so. 



Adaptive Wealth Strategies is an investment division of Carroll Financial, a Registered Investment Advisor.  Advisory services offered through Carroll Financial Associates, Inc., a Registered Investment Advisor. Orders to buy or sell securities cannot be accepted via e-mail or voicemail. E-mail correspondence is routinely monitored for regulatory compliance purposes. Everything we’ve discussed is just our opinions, they should not be construed as a suggestion to buy or sell any specific investment.  All Information is believed to be from reliable sources; however we make no representation as to its completeness or accuracy. All economic and performance information is historical and not indicative of future results.  You cannot invest directly in an index.  Past performance does not guarantee future results.