Smart Beta Investing in European Stock Markets

Aleksi Anton Salonen & Daniel Weissenbacher

Student thesis: Master thesis

Abstract

This paper studies the return and risk characteristics of various smart beta strategies in the European equity markets. We research risk-adjusted returns of strategies employing size, value, profitability, momentum, and low-beta factors. The main question is whether smart beta portfolios are capable of outperforming a value-weighted index in the period from 2002 to 2020. The thesis studies data on the 600 largest listed companies in Europe over the 21st century available. The stocks are sorted into decile portfolios by each factor and the extrema based on previous literature is selected to represent the single-factor portfolio. Two alternative approaches for smart beta portfolio construction are contested in search of optimal methodology: integration and mixing. We find consistent evidence that the integration approach generates superior performance over the mixing approach. Smart beta strategies’ superior performance over the index is significant in magnitude. Including additional factors to a smart beta strategy seems to behave in concave fashion, peaking at three factors on average, when the return on risk is at highest. After the third factor the focus seems to be lost as marginal diversification of risk falls sharply and returns of the portfolio fade. An investor finds better risk-return trade-off on average at three-factor smart beta strategies and is inclined to use a four- or five-factor model. The value and size factors have limited performance within our sample, but the newer factors low-beta, momentum and profitability express strong potential. We find little statistical significance in asset pricing models and cannot reject the possibility of luck causing the performance of smart beta portfolios. The setup in the paper complements existing literature and is relevant for the majority of investors as the methodology was set up to be applicable to a greater audience considering investing limitations, such as shorting constraints and a low degree of active management

EducationsMSc in Finance and Investments, (Graduate Programme) Final Thesis
LanguageEnglish
Publication date2021
Number of pages136