Smart beta approach of index base investing and the factor investing phenomenon-The Turkish case

Traditional Capital Asset Pricing Model (CAPM) tests use a cap-weighted equity market portfolio as the market proxy for the CAPM market portfolio. A majority of these tests have found that either the CAPM relationship does not hold (a true failing of the model), or the equity market portfolio is not a good proxy of the CAPM market portfolio. Consequently, these empirical findings directly challenge the mean-variance optimality of the market portfolio. As cap-weighted indexes bear a natural bias towards large-cap and overpriced stocks, they have relatively limited exposure to underpriced (i.e., value) stocks. Many index-based techniques have been introduced in recent years to overcome this bias and unlock the potential for value investing, like smart(alternative) beta index investing and factor investing. This study challenges CAPM's original conviction that a passive investor/manager can do no better than holding a market portfolio in the Turkish equity market context. According to CAPM, generating a positive alpha (abnormal positive return) through an active investment strategy is not possible, and any such achievement should be attributed to the chance factor. We challenge this conviction and use Arnott, Hsu, and Moore's (2005) fundamental indexation (also referred to as smart or alternative) beta indexing) methodology and Ang, Goetzmann, and Schaefer's (2009) Factor Investing approach (adapted from MSCI-Foundations of Factor Investing (2013)) alternatively. Using these alternative methodologies we tested whether a positive Jensen's alpha generation is possible through the introduction of these new risk factors. This analysis was limited to the Turkish equity market.