How the pandemic taught us to turn smart beta into real alpha
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ORIGINAL ARTICLE
How the pandemic taught us to turn smart beta into real alpha Christopher Kantos1 · Dan diBartolomeo1 Revised: 22 October 2020 / Accepted: 23 October 2020 / Published online: 17 November 2020 © Springer Nature Limited 2020
Abstract The ongoing COVID-19 pandemic has strongly reminded equity investors that rare but extreme events occur from time to time. At the individual firm level, such events also impact the likelihood of bankruptcy, a feature that is not well represented in the traditional Capital Asset Pricing Model. This paper presents a functional form for equity asset pricing that is realistic, and reconciles the observed high equity risk premium with the observed lower than expected slope of the Security Market Line. Most importantly, we will demonstrate how including the potential for such large events changes traditional views of equity returns and the known factors that contribute to those returns. On the basis of empirical examination of a dataset stretching over 30 years without survivorship bias, we conclude that when the probabilities of rare extreme events are considered, strategies that focus on “alpha” (risk adjusted return) as defined in Jensen (J Finance 23(2):389–416, 1967) are structurally superior to “smart beta” strategies that seek to outperform a market index benchmark. Keywords Alpha · Asset pricing · CAPM · Equity risk · Factor returns · Smart beta
Introduction The ongoing COVID-19 pandemic has strongly reminded equity investors that rare but extreme events occur from time to time. These events represent periods of increased volatility and in some cases very negative market returns for extended periods. At the individual firm level, such events also impact the likelihood of bankruptcy, a feature that is not well represented in the basic asset pricing literature. This paper presents a contribution to the financial literature by proposing a functional form for equity asset pricing that is both realistic and can be easily tested with a widely used data set extending over 30 years. Most importantly, we will examine how including the potential for such large events changes traditional views of equity returns and the known factors that contribute to those returns. By incorporating the probability of such rare events in equilibrium factor models, we conclude that strategies that focus on “alpha” (risk adjusted return) as defined in Jensen (1967) are structurally superior to “smart beta” strategies that attempt to outperform an equity index by active exposure to one or more recognized factors. * Christopher Kantos [email protected] 1
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There are several historical features of equity market asset pricing that we will seek to explain. The most obvious is that the equity risk premium (return of equities minus the risk free rate) is widely considered to be unexpectedly high. This has led some researchers to argue that long-term investors should always be fully invested in equities (e.g., Siegel 2014). At the same time, t
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