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T ransparent rules-based index-tracking portfolios that employ alternative weighting schemes have grown rapidly in the last decade, especially within equities. Today these types of non-market-cap-weighted portfolios go by the term "advanced beta," "smart beta," "systematic strategies," "factor-based investing," and more. These strategies are passively implemented in the same way as traditional passive portfolios. Because of this, they retain the benefits of passive management including full transparency and low costs, with the potential to earn higher returns and/or deliver lower volatility than market-cap-weighted portfolios. Particularly over long periods, many investors are increasingly viewing them as a more cost-effective way to enhance returns. A wealth of papers has been written on these non-market-cap-weighted strategies, which we refer to as advanced beta strategies for the remainder of this article. 1
The earliest advanced beta strategies applied an alternative weighting scheme to market-capitalization weighting. Examples include GDP-weighted portfolios, equally weighted portfolios, and more recently, fundamental-weighted portfolios. GDP weighting applies GDP weights as country weights in a global equity portfolio, while equal weighting and fundamental weighting assign equal weights to securities or weights based on company fundamentals like book value, respectively. Proponents of these strategies were typically critical of cap weighting and argued these alternative weighting schemes were superior either because they were more representative of investment value or more diversified (less concentrated).
In recent years, an alternate way of viewing advanced beta portfolios has emerged, one that focuses on the underlying factors, driven in no small part by the ballooning number of available strategies in the marketplace. This approach focuses on what factors (value, size, quality, and so on) the portfolios are exposed to, and derive their returns from. It is generally more consistent with the way academics have viewed factors, most widely popularized by the Fama French [1992, 1993] seminal three-factor model. Equal weighting for instance has been argued to capture size and rebalancing effects; see Hamza et al. [2007]. Fundamental weighting has been argued to capture size and value factors; see Arnott et al. [2013]. Both increasing familiarity with traditional academic factor models and the rapid proliferation of advanced beta strategies have driven greater adoption of this approach, since it simplifies the comparison of different portfolio construction approaches. The tilted portfolio framework we outline next originates...