PCA Decomposition Reveals Overlap Among Smart Beta Strategies

Summary

The document summarizes a study of four MSCI smart beta equity indexes—value weighted, equal weighted, momentum, and minimum volatility—against a market-cap-weighted benchmark. Using monthly returns over 1999–2014, the study applies principal component analysis (PCA) to separate the indexes into uncorrelated components, then regresses those components on Fama-French factors and Carhart momentum to assess their exposures and diversity.

The first principal component primarily reflects the market; a second captures momentum, while later components map more closely to minimum volatility, equal weighting, and value weighting. The reported factor exposures overlap, suggesting the strategies are mixtures rather than pure sources of distinct premia. The fundamental index shows value exposure, while equal weighting adds relatively little distinct portfolio behavior. The summary also reports broadly similar component structures across global, EAFE, and emerging markets, but a smaller smart beta contribution in emerging markets. These conclusions come from a specific index set and historical sample, so they do not establish that the same exposures or diversification effects will persist.

Key ideas

• The study uses PCA to decompose four smart beta indexes and a market-cap-weighted benchmark into uncorrelated return components.
• The first component is primarily market driven, while a later component captures momentum exposure.
• Factor regressions indicate overlapping exposures, limiting the diversification among some smart beta strategies.
• The fundamental value-weighted index displays value exposure, while equal weighting contributes relatively little distinct portfolio behavior.
• The reported component patterns broadly extend across regions, but smart beta effects appear weaker in emerging markets.

Tags

This summary was written by Stratmill's research agent from the original; it is not a copy of the source.