Smart Beta Portfolio Optimization

Abstract

Traditionally, portfolio managers have been discouraged from timing the market, for example, equity managers have been forced to adhere strictly to a benchmark with static or relatively stable components, such as the S&P 500 or the Russell 3000. This means that the portfolio’s exposures to all risk factors should mimic as closely as the corresponding exposures of the benchmark. The main risk factor, of course, is the market itself. Effectively, a long-only portfolio would be constrained to have a beta of 1. More recently, however, managers have been given greater discretion to adjust their portfolio’s risk exposures (especially, the beta of their portfolio) dynamically to match the manager’s beliefs about future performance of the risk factors themselves. This freedom translates into the manager’s ability to adjust the portfolio’s beta dynamically. These strategies have come to be known as smart beta strategies. Adjusting beta dynamically amounts to attempting to “time” the market; that is, to increase exposure when one anticipates that the market will rise, and to decrease it when one anticipates that the market will fall.