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How the pandemic taught us to turn smart beta into real alpha

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  • Christopher Kantos

    (Northfield Information Services, Inc.)

  • Dan diBartolomeo

    (Northfield Information Services, Inc.)

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.

Suggested Citation

  • Christopher Kantos & Dan diBartolomeo, 2020. "How the pandemic taught us to turn smart beta into real alpha," Journal of Asset Management, Palgrave Macmillan, vol. 21(7), pages 581-590, December.
    • Handle: RePEc:pal:assmgt:v:21:y:2020:i:7:d:10.1057_s41260-020-00195-w
    DOI: 10.1057/s41260-020-00195-w
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    References listed on IDEAS

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    2. Lorenzo Casavecchia & Gerhard Hambusch & Justin Hitchen, 2022. "The impact of analyst forecast errors on fundamental indexation: the Australian evidence," Journal of Asset Management, Palgrave Macmillan, vol. 23(5), pages 400-418, September.

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