Smart-Beta Perspectives: Are you confused as well?

In a nutshell

Smart-beta is lower cost approach to rule-based algorithmic active management. In general, nirvana is to outperform the market, the strategy here is to use risk factor tilts which historically delivered risk premia. Outperformance, if any, is usually at the cost of higher volatility/risk without necessarily delivering sustained risk-adjusted return. Capacity limitations suggest that any improvements observed would be transient. Many smart beta strategies can be replicated at lower cost using combinations of passive index funds. Much of the benefits of smart beta, such as lower cost “price discovery” and shareholder activism, will accrue to passive index investor. The important benefit to active investors is a reduction of the frictional costs of active management. If the impact of higher risk fund strategies is not managed properly at the portfolio level, this may increase the buy-high/sell-low  behaviorally driven gap between long term returns delivered by funds vs. actual returns reaped by investors in the funds. Less risk tolerant investors such as retirees may also be challenged by increased collateral damage of the higher risk (e.g. sequence of return risk). I personally have not as yet succumbed to the siren call of “smart-beta”.

Background

I first came across a smart beta product/strategy called “fundamental indexing” described by Rob Arnott of Research Affiliates about a decade ago. Over the past decade interest has been growing significantly in smart-beta products.  In fact according to a recent Bloomberg article, smart-beta strategies have now captured 20% ($400B) of the $2T domestic ETF assets. Examples mentioned include: Guggenheim S&P 500 Equal Weight ETF, WisdomTree Europe Hedged Equity Fund, ProShares Large Cap Core Plus, Research Affiliates’ (fundamental index)  PowerShares FTSE RAFI US 1000 Portfolio. Also considered to be employing smart-beta strategies, though unavailable in an ETF form, are Dimensional Fund Advisors (DFA) funds which have garnered of the order of another $400B under management. DFA funds are only available to retail investors through advisor channels packaged together with advice (and its additional cost); they are also available in some 401(k) and institutional channels.

The debate has been raging for years whether smart beta strategies: what are these funds trying to do and how? Are they passive or active, Are they index funds or not? What is smart beta and how does it differ from dumb beta? Where is the smart money and dumb money going?

The purpose of this blog post is to discuss and try to answer some of these questions, even though I don’t claim to have personal experience or in-depth expertise in the subject, since so far I personally have not succumbed to the siren call of “smart-beta”.

The approach used is to peruse the views of many smart people, whether smart-beta advocates and detractors/heretics, academics and/or industry experts, academic researcher and financial product developers and/or sellers with and without implied conflicts of interest on smart beta.

There are lots of smart people on both sides of this debate but as we have often heard it said in the investment world “Past performance is not a guarantee or even indicative of future results”, only future return matter. Some of the advocates of smart beta call strategies index but not passive, others say passive but not index, and others say passive and index. This is not surprising because assets have been pouring into the passive and index categories for at least a decade and if smart beta is passive and index then why not benefit commercially from being painted with the same brush, if possible.  But many smart beta heretics, and at least some advocates call smart beta a form of active rather than passive management. And as we have often heard, active strategies have in the aggregate failed to outperform their passive benchmarks after costs (fees, transaction, taxes, etc). Even if smart beta strategies would have out-performed in some sense so far, there is a lot of skepticism that risk factor related risk premiums (on which most smart beta strategies rely) can be maintained due to capacity limitations as people/assets pile into a strategy, and whether investors will stay put or abandon ship if/when strategy inevitably underperforms. Furthermore, there is the question of how much outperformance can be realized on a portfolio level after factoring in higher smart beta fund costs, advisor fees when one is used, and when the typical portfolio might only be around 50% allocated to equities.  (Of course advisers following best practices may also add value, beyond portfolio implementation,  by providing an IPS, risk management (insurance) and estate planning assistance, all in a fiduciary level-of-service wrapper to insure that clients’ interests prevail in all decisions/actions; so not all advisory fees should be allocated to the portfolio).

The details

Given the considerable confusion surrounding smart beta, perhaps the best way to tackle the subject is to see various experts’ perspectives (pro and con) be they advocates or heretics. But before I get into quoting other expert perspectives, we need to define beta, indexes, and smart-beta.

Advocates suggest that “Smart-beta” is a new/brilliant advance in investment strategy, while detractors suggest that it is just a new/brilliant marketing term. But the term itself probably obfuscates more than illuminates. In Reilly and Brown’s “Investment Analysis Portfolio Management” (7th edition) in the context of Sharpe’s CAPM (capital asset pricing model) the market portfolio includes “all risky assets in the economy…in proportion to their market value. This market portfolio should contain not only U.S. stocks and bonds, but also real estate, options, art, stamps, coins, foreign stocks and bonds, and so on, with weights equal to their market values. In Litterman interview with Sharpe “Past, present and future financial thinking” Sharpe explains that when he created CAPM he was focused on “market sensitivity” which was a measure of the sensitivity of the price of an asset to “changes in the value of the overall market portfolio”; many called this sensitivity beta. The sensitivity of the market to itself is 1.0 by definition (i.e. market beta=1), while an asset with a beta>1 is riskier than the market (i.e. an asset beta=1.2 is 20% riskier than the market), whereas an asset with beta“Beta” came to represent market return. Theoretically access to “beta” (the market) is free (with existing market index funds beta is actually almost free), but “alpha” (outperformance due to skill/luck) is difficult to get (i.e. takes work and is expensive) especially on a predictable and sustained basis.

So beta represents all risky assets, which you will hear at times approximated by the stock market in the US or ex-US or the world, as the case may be. Then what is smart beta? The Economist’s “The rise of smart-beta” explains smart beta as follows: ““beta” is the return achieved from exposure to the overall market, for example via an index fund (which is a capitalization weighted implementation of the market). “Smart beta” is an approach that tries to enhance the return from tracking an asset class by deviating from the traditional “cap-weighted” approach, in which investors simply buy shares or bonds in proportion to their market value… There is a variety of smart-beta approaches. The simplest is to give each market constituent equal weight. If there are 100 stocks, then each would have a weighting of 1%. A second approach, dubbed “fundamental indexing”, is to weight each company by its financial characteristics—sales, dividends, assets or cashflow. A third is to weight the index in terms of the volatility of the stocks, with the least volatile being favoured. A fourth is to use the “momentum effect” to buy stocks that have recently risen in price. That’s just for starters.” (Any expected differences in  a smart beta strategy outcomes as compared to a capitalization weighted index based portfolio, are as a result in different weightings of risk factor (e.g. small, value, etc) exposures and their associated historically higher risk premia.)

If Beta is supposed to represent “the market” by definition, then something different than beta (e.g. a smart-beta which can be a great variety of things depending on who of who is defining it) is not the market. The more we drift away from that market definition the less representative that basket is of “the market” and the more active (less passive) is the investment strategy. So, I suspect if you think about it a little bit, you might conclude that smart-beta might be either as misnomer or an oxymoron.

So what is an index? As one can imagine it would be very difficult to create the complete market portfolio as described above, i.e. including all risky assets. An index is a selection of stocks (meeting certain criteria) specified by indexers (i.e. organizations in the business of constructing indexes) and weighted in proportion to their market value, which adequately represents the market of interest and is a suitable benchmark for it. So indexers define market(s) and corresponding indexes, and the capitalization weighted indexes are most representative (by definition of market); they are also easy to manufacture (i.e. create index portfolio), cheap to maintain (low turnover as: index reconstitution adding/removing of stocks is minimal, rebalancing in response to asset value changes relative to the market is automatic), tax efficient, low cost, etc. Examples of such indexes/portfolios representing various markets or submarkets are: S&P 500 (largest 500 U.S. public companies subject to some qualifying rules), and Total U.S. Stock Market Index (‘all’ U.S. publicly traded stocks, about 4000, again subject to some rules), similar constructs were developed to the European and Asian Developed Markets and then extended to Emerging Markets. These were then combined to create global indexes getting an increasingly better approximation to “the market” of risky assets.

Gradually indexes were further divided into sub-indexes. With the recognition of higher risk premiums associated with smaller and lower-priced (by some measures) companies, style investing came along to allow investors to focus on narrower subset such as: small and medium size stocks and value or growth stocks and even narrower combinations of these like small-value or large-growth for example, something for everyone. Active fund managers, though often accused of being closet indexer but charging higher than index prices, can in fact be unconstrained stock pickers and can invest in anything they believe in, limited only by specific mandates (e.g. small cap or micro cap or growth or whatever) if any. Active investment managers always have their strategies on how to pick their stocks. With the “smart-beta” wave many of the active managers (specifically ‘quants’ or quantitative analysts) are encoding their recipes via algorithms into “smart-beta” funds which in effect could be considered proprietary/custom indexes. Such indexes (called by some as “active indexes”) can differentiate themselves not only by their algorithms, but also in the frequency of applying the algorithms to reconstitute their funds.

As I mentioned before, I came across the subject of smart beta about a decade ago when Rob Arnott published his fundamental indexing paper suggesting that while cap  weighting has inherent advantages such as: being passive and requiring little trading, having lower costs/fees than an active strategy, being more broadly diversified, offering superior “trading liquidity” and enable the” use of passive strategies on an immense scale”, the fundamental indexing  proposed indicates back-tested results with about 2% higher return over about four decades ending in 2004. It was argued that this outperformance resulted from overcoming the inefficiencies of capitalization weighted indexes such as “overweighting overpriced stocks and underweighting undervalued stocks…Fundamental Index strategies have a value tilt and a slight small-cap tilt. These tilts, however, are dynamic: when the value stocks are out of favor and thus are cheap, tend to increase their allocation to deep value stocks.” DFA started even earlier the factor based investing built on the Fama and French three factor model and its extensions, initially the factors were market, size (small) and Value (vs. growth); later profitability was added.

But, it is generally believed, there is “no free-lunch”.  If “Smart-beta” implementation outperforms the market, it comes with higher risk than the market which is rewarded with a higher risk-premium than the market. But it is not just more risk. For example the MSCI paper “Harvesting risk premia” notes that “Portfolio returns were traditionally attributed to passive market exposure and active portfolio management. Any return in excess of the market return was considered added value from active management. More recently, many return components that were considered added value (alpha) are increasingly being recognized as risk premia (beta)” (i.e. much of the “alpha” was as a result of risk premia associated with risk factors like small size or value, etc). But then they go on to observe that while “Growing popularity and increasing allocations into risk premia (factor based) strategies may remain powerful tailwinds for the performance of these strategies for the foreseeable future. However, as these strategies start to attract increasing amounts of capital they may start to reflect diminishing factor premia over time.” (i.e. too many dollars chasing low capacity strategies will drive up prices and reduce risk premia of those risk factors). One can think of this phenomenon as pertaining to the capacity of a strategy; the narrower the slice of the market addressed by a strategy, assets pouring into it (and its imitators) will increase its price disproportionally to the point where its risk premium could be eroded and might even become lower than that of the market.

So, with the future being unknown and unknowable, factors based strategies may come and go, but the only certain thing is the drag resulting from frictional costs. So investing in “the market” to partake in the market risk premium at the lowest cost, should continue to be a persuasive argument that should be considered by all investors. This does not mean that some smart-beta which is (at least partially) active can’t outperform the market, but like with traditional active strategies we can’t know a priori which will outperform and whether or how long it will continue to do so. What we do know is that currently most active managers underperform the market after expenses, and smart beta strategies come with lower expenses than for active management, so this may result in a smaller proportion of funds/managers underperforming their passive competitors than traditional active funds. Ferri  notes that “Active management is uncompensated risk. The odds are against picking a winning fund, and the payouts don’t justify the risk. While it is possible to beat the market with active management, it is not probable, and the payout just isn’t there.”

There is considerable debate on whether these algorithmic smart-beta approaches are passive or active, and whether they are a form of indexing (implement a market index and measure their performance against it) or not. Still others argue that they are passive but not index based (given that market indexes are cap-weighted by definition). I would be inclined to say that these are closer to the active than passive end of the scale since they implicitly involve stock selection, though based on rules/algorithms implemented often in a transparent fashion and at lower cost than traditional active funds. As to whether this is indexing, perhaps, since it is based on a set of rules/algorithms (though different than capitalization weighted market index), but this index is the smart-beta fund managers’ own custom/proprietary index, rather than a 3rd party index provider’s. However the smart-beta originator might (unfairly) try to compare its performance against one of the passive capitalization weighted indexes to prove its superiority even though it likely has different risk characteristics than the latter. Many even call smart beta implementations “active index”.

Some expert perspectives

(We’ll now look at expert perspectives including my comments in italics/brackets for clarification not criticism.)

 

In Bloomberg’s  “Attack of the algorithms”  Effinger and Balchunas write thatthe essence of smart beta, or strategic beta, or scientific beta, or factor-based investing, or fundamental indexing, depending on which Ph.D. is talking…It’s index investing with key twists, all of them rules-based, with no active management required (though many would disagree and argue that the very act of stock selection and periodically re-applying the non-cap-weighted rules is the essence of active management). Most smart-beta funds track custom (or even proprietary) indexes. Some are simple variants of the Standard & Poor’s 500 Index and do what they say on the box. Others are hand-crafted and small batch, made by people with little more than a stock-filtering system and a dream…. beta means return you get simply for taking the risk of owning stocks (the more colloquial use of the term beta refers to market risk i.e. beta=1). The much rarer alpha is extra return from spotting something that the market missed. Despite what human managers say, alpha is rare. Smart-beta enthusiasts accept that and try to better mine the returns from beta using an eclectic range of strategies, filtered for various factors and united by their set-it-and-forget-it rule books.” (As noted earlier there is not much alpha lying around to be had, i.e. it’s very rare to find $100 bills on the sidewalk that others have overlooked (market is efficient), so one needs to reach for higher risk to enhance return.) The Bloomberg article includes the following comments from smart beta advocates and heretics like Arnott, Bogle, Ferri and Booth:

Arnott (father of fundamental indexing): “What smart beta does best is sever the link between the price of a stock and its weight in an index (while literally true, there is no unanimity on how key this is in the results achieved-see Malkiel below)… By linking the weight to price, the more expensive something is, the bigger your holding… the machine will make hard trades when the human won’t (this can get confusing because, in a cap-weighted index implementation there is no rebalancing needed within the equity asset class represented by the market, trades would only be required infrequently when index is reconstituted (i.e. a stock is either moved in or out, fine tuning of weight to return it to a level proportional to the capitalization value may be required), whereas in a smart-beta type strategy typically rebalancing/reconstituting gets fuzzier and the algorithm tends to be applied with a much greater frequency and weights can vary a great deal not being capitalization related)… It won’t hesitate to pick up damaged goods at a fire sale, and it will hang on when the world looks ready to end. The more uncomfortable the rebalance (or perhaps more the reconstitution), the more likely it is to be profitable.

Bogle (father of capitalization weighted indexing): “Don’t mention smart beta in this office!…I don’t even know what it means. Baloney. Marketing!”

Ferri (author columnist, advisor, low cost indexing advocate): “smart beta is a ploy for active managers to retake some of the billions lost to Bogle and his low-cost indexes. If an active manager has an investment strategy that shows positive returns over the past decade or so, and it can be encoded in an algorithm, he can call himself an indexer, charge higher fees for his secret sauce, and kick back and get rich…Everything that used to be active management became fundamental indexing”. Ferri then takes it a step further in Investing in Style with Index Funds and writes that “Style (e.g. value or size) investing is an active management strategy whereby an investor overweighs their portfolio to growth or value stocks in an attempt to outperform the broad market.” His arguments that this is active investing are three-fold: “First, selecting stocks based on fundamental valuation is the very essence of active management. Second, turnover of holdings within a style index is significantly greater than a beta seeking broad market index. Third, all style funds are always more expensive than broad market index funds, just as active management is more expensive than indexing in general.”   Ferri says if you want a style tilt, it is cheaper and more flexible “to create a style tilt using two separate funds, one that provides cheap beta exposure and a second that provides concentrated exposure to value stocks. The two fund approach allows an investor to control risk exposures based the amount dedicated to value stocks.”

Booth (Co-CEO of DFA Funds, who also explains their approach in “The evolution of Dimansional”): seems to agree with Ferri when he “recently joked about his 30-year-old company’s investment approach. Once an ardent believer that his firm was a passive indexing shop, Booth now says, “As we’ve gotten older, I’ve started calling ourselves active. We work so hard it’s a shame to call us passive. But on the other hand, if you want a passive manager – then we’re passive.” (J)

Bernstein: “Is there a lot of dumb money going into smart beta?’’ he asks. Probably, he says, and it makes him wary. “When I own an asset class, I ask how savvy my co-owners are. Here, you’re getting an influx of undisciplined investors who think they’re getting a free lunch.” (Dumb money?)

In the Financial Analysts Journal Robert Litterman interviews William Sharpe in “Past, present and future financial thinking” (p. 20-21):  Sharpe argues very persuasively: “I always approach any investment decision as follows: If x is a good thing for almost everyone, then what happens if everybody does it? Or what happens if the people for whom it’s a good thing do it? Will markets clear? Is a strategy consistent with what everybody else wants to do—that is, macroconsistent?” (Does the strategy have the capacity, i.e. will it executable and will it continue to work as more and more people/assets pile in?) In Sharpe’s Capital Asset Pricing Model (CAPM) “market sensitivity” is a “measure of how sensitive the price or return of an instrument- a stock or portfolio- is to the changes in value of the overall market portfolio” so “beta was more than just the sensitivity to a single factor” in the factor model… “when I hear “smart beta,” it makes me sick. By definition, if you’re talking about doing better than an appropriate benchmark, then it’s important that you specify what the benchmark is. If the benchmark is not the market portfolio, that’s fine. You can say, “I’m going to beat the market more often than not.” We used to call that “alpha.” Or if you say, “I’m going to beat the market by tilting toward small stocks, away from the market proportions,” then that’s fine as well. That is a factor bet or a factor tilt.” “If your story is that you have found a way to exploit stupidity and if you’re right, I would suggest that before too long, the really dumb investors will begin to choose index funds or move in your direction, as may some of the index fund people. If so, your edge will diminish and eventually disappear… believe that, either intentionally or unintentionally, the current use of the term by active managers adds to confusion and doesn’t help clarify matters. Also, I doubt that many of these active management strategies will be winners in the future.” (Effectively: smart beta is active, if strategy has an advantage it will gradually disappear as people recognize it and shift assets into it)

 

John Authers in the Financial Times’  “Is ‘smart beta’ smart enough to last?” articulates the Sharpe’s thinking very simply when he writes that “Critically, he (Sharpe) argues that smart beta providers cannot argue that their approach will work if everyone does it. Logically, they rely on “dumb beta” staying dumb, buying stocks that smart beta providers sell, and never learning that cheap and small stocks tend to outperform.” Stung by the criticism “smart beta providers are producing research showing their strategies win not because of factors such as value, that will be arbitraged away over time, but because of rebalancing. Put simply, any strategy that regularly buys losers and sells winners will do well.” (i.e. the real source of improved returns of smart-beta strategies is the higher frequency of rebalancing/reconstituting.) In another Financial Times article “Why multi-factor funds are smarter beta” Authers opines that “smart beta is the catch-all term for rules-driven quantitative strategies that take major indices and reweight them so as to create a better chance of beating the market in the long term — if all goes well… The greatest problem with the concept is that if it is successful, it should carry the seeds of its own demise. Once investors have cottoned on that cheap stocks outperform, more will buy them and the anomaly will disappear… even as these factors should logically lose their power in the longer run, there is also the problem that they tend to be cyclical… The new answer is to create multi-factor funds. Combine several factors in one fund, and you will always have the dominant factor of the moment pulling you through… These funds are fascinating… But explaining what they (multifactor funds) do is difficult… When it comes to finding a market for them, that could be a problem.”

Olly Ludwig interviews Burton Malkiel in ETF.com’s ”No free lunch with ‘smart-beta’” where Malkiel  was quoted as:

Malkiel (author of “Random walk down Wall Street” and CIO for successful robo-advisor WealthFront which uses passive index funds) opines that: “they (smart-beta) are often mis-sold. To give you an idea, that so-called fundamental indexing, the RAFI ETF, is sold as a way in which you can avoid the overpriced stocks in the market. And that simply isn’t true. Rob Arnott’s argument against what I would call pure-vanilla indexing is that if a stock goes up and gets overpriced, it’ll have too big a weight in the index and you’ll be holding too much in overpriced stocks. I think that’s basically wrong… One of the things smart beta does do is emphasize value, which is actually implicitly what Arnott does. And it works sometimes and it doesn’t work other times… the one period where RAFI really outperformed, was actually coming out of the financial crisis. And in 2009, RAFI doubled the weight of bank stocks and had 15 percent of the portfolio in Citigroup and Bank of America… we were thinking that the government might very well nationalize the banks. The banks were cheap, relative to book value… But holding a portfolio that had 15 percent in a couple of stocks that were teetering on the edge was a bet that worked. But don’t tell me that that wasn’t risky… it’s the only period that he outperformed. But don’t tell me this was because he avoided overpriced stocks.”

Things get even more confusing pretty quickly, as we start discussing whether smart-beta funds are active (as DFA co-CEO Booth indicated above) or passive (as Swedroe and Solin suggest below) and whether they are index based or not. For example, DFA (Dimensional) limits retail access to their funds only via advisors. These advisors apparently are selected for a predisposition to and are trained for keeping the client/investor from fleeing in panic from volatile markets; some are even calling themselves “passive advisors”. This is an important value delivered by advisors in general, but particularly useful for smart-beta investors, like DFA, as any higher returns are typically obtained are as a result of additional risk. It is well known from regular DALBAR reports (e.g. see Zweig in WSJ’s “Just how dumb are investors”) that U.S. stock investors earned a much lower 3.7%/year return over the past 30 years than earned by the funds they invest in like the S&P 500 which returned 11.1%; this is because investors tend buy after they have gone up and then throw in the towel after they have gone down. Many DFA advisors, often well known and respected names, argue vehemently that DFA funds are passive explicitly or by implication. For example Larry Swedroe in ETF.com’s  “Don’t Believe The Active Hype” writes thatWe’ll compare the performance of these 11 actively managed funds with funds in the same asset class that are managed by Dimensional Fund Advisors (DFA), the leading provider of “passively managed asset class funds” that aren’t also index funds.” Or,  Dan Solin in Huffington Post’s “Solving the mystery of passive asset class investing”  makes a distinction between indexed based “passively managed” fund which “seeks to “passively” track a benchmark index, like the S&P 500….(and) have many of the benefits of index funds…low cost, have low turnover and are tax efficient|, compared to “passive asset class fund” (like DFA which has additional advantages of: “flexibility when to buy and sell stocks”, “flexibility in stock selection”, “use of block trading techniques”, and “tax efficiency”  by minimizing short-term gains, tax loss harvesting, avoid stock buying just before ex-dividend date (sounds neither passive nor index). (So they are passive in some sense but not index?) However,  “DFA vs. Vanguard” summarizes an interview with Weston Wellington (DFA VP) as follows:  “The most significant thing that DFA and its network of authorized advisors do is to tilt portfolios toward small and value stocks.  These higher risk stocks have higher expected returns.  You can tilt a portfolio of non-DFA index funds to small and value easily enough, but many do-it-yourself indexers don’t whereas very few users of DFA funds don’t have a significant tilt to these risk factors. When asked whether the additional expected return was a “risk story” or a “free-lunch”, Wellington indicated that he was in the “risk camp”, “emphasizing that the future may very well not resemble the past and the risks of small, value, and profitable stocks may very well show up in the future and provide lower than market returns over a long time period.” (Neither passive nor index?)

In ETF.com’s “3 fine passive funds compared” Swedroe: compares Vanguard/DFA/Bridgeway’s small value fundsnot all passively managed structured asset-class funds attempt to replicate the returns of popular retail indexes, like the S&P 500 or the Russell 2000… nonindex passive funds (DFA is what he advocates) tend to use academic definitions of asset classes to structure portfolios for the purpose of minimizing the weaknesses of indexing”, such as: monthly vs. annual reconstitution results in “more consistent exposure to an asset class”, “forced transaction as stocks enter and leave an index”, “risk of exploitation through front-running”, “inclusion of all stocks in the index”, “limited ability to pursue tax-saving strategies”…taking better advantage of factor exposures (“size, value, momentum, profitability, carry and term”) e.g. increasing exposure to “smaller and more “valuey” stocks than a small cap  value index might contain” or to more ‘highly profitable companies” and avoiding stocks “exhibiting negative momentum”, REITS are excluded. Comparing three funds Vanguard, DFA and Bridgeway he concludes that: differences in performance are explained by the “fund structure”, Fama-French three-factor model (market, small vs. large, value vs. growth as in DFA funds) works well to explain differences in performance of portfolios “When an asset class does well, you should expect the fund with the greatest exposure to whatever factors explain that asset class’ outperformance to have the highest return. And when an asset class does poorly, you should expect the fund with the most exposure to those factors will underperform.” (i.e. the more you climb out on the risk scale along the smaller and more “valuey” companies the greater your outperformance/underperformance over periods when those factors over/under-perform) Allan Roth in ETF.com’s “Retort to problems with index funds” has 9 answers to Swedroe’s 9 problems with index funds, and the debate goes on and on.

In the Financial Analysts Journal’s  “My top 10 peeves” Assness (respected quant asset manager) and Liew:  “To me, if you deviate markedly from capitalization weights, you are, by definition, an active manager making bets. Many fight this label. They call their deviations from market capitalization—among other labels—smart beta, scientific investing, fundamental indexing, or risk parity. Furthermore, sometimes they make distinctions about active versus passive based on why they believe in their strategies. You can believe your strategy works because you’re taking extra risk or because others make mistakes, but if it deviates from cap weighting, you don’t get to call it “passive” and, in turn, disparage “active” investing. This peeve may be about form over substance—marketing versus reality—but these things count…. I think people should call a bet a bet. If you own something very different from the market, you’re making a bet and someone else is making the opposite bet.” (No question that smart beta is active!)

In AQR’s “Smart-beta not new, not beta, still awesome OR How I learned to stop worrying and love smart-beta” Assness: “ Smart Beta1 is mostly re-packaged, re-branded quantitative management… It takes well-established, quantitative investing styles, or factors, and implements them in a simple, transparent manner often, though not always, at lower fees than what we’ve seen in the past. (It’s all about branding, marketing and packaging!)

Questioning smart beta outperformance?

Let’s look at some of the recent performance data resulting from smart beta strategies. In Alpha Architect’s “How smart are smart beta ETFs” Stanley Gray indicates a new research paper by Denys Glushkov “concludes that the benefits of smart beta are questionable…I find no evidence that SB (smart-beta) ETFs significantly outperform their risk-adjusted passive benchmarks”. Essentially, his dismal findings indicate that while “60%  (9 out of 15) of smart-beta categories outperformed their raw declared benchmarks”, but “only one category (value) significantly outperformed its risk-adjusted benchmark” and “none of the smart beta categories significantly outperformed the blended benchmark (i.e. one “constructed as an annually rebalanced combination of passive existing funds representing the broad stock market and various factor exposures (size and value)”)”.

Furthermore in ETF.com’s “‘Smart Beta’ Looks Like Expensive Beta” Dan Egan argues that “it’s important to understand that a market-cap portfolio is a factor portfolio. It just takes on the market allocations of each factor. Investing in “smart” beta portfolios means the manager overweights some factors and underweights others. Some of these may be static overweights, while others may be dynamic, depending on the market cycle. However, while the jury is still out on whether actual implementations successfully produce alpha, most evidence implies they don’t.” In addition to points made by Glushkov above, Egan notes other cost issues with smart beta:  “Higher (and hidden) costs to the consumer” (cost of higher turnover, liquidity cost (bid-ask spread), tax transaction costs. “If you’re bearing uncertainty, you should be able to demand to be paid more, especially net of fees and taxes. Smart-beta funds appear to be based on the opposite notion; namely, that the investor should bear known higher costs—management fees, transaction costs and tax costs—in exchange for the very uncertain chance that active indexes will outperform on average and over a long period of time. And it’s far from certain that documented historical performance by smart-beta factors will persist.”

The NYT suggests that DFA’s real value to investors in general is that they are “Challenging management (but not the market)” “Dimensional’s expense ratio for its stock mutual funds was 0.396 percent, through February, compared with only 0.138 percent for Vanguard’s. The comparable figure for all other stock mutual funds was 0.902 percent…. On an asset-weighted basis in the 10 years through Jan. 31, the return received by Vanguard investors was 6.614 percent, annualized, compared with 5.05 percent for Dimensional funds, Morningstar calculates…(but) “Dimensional was ranked No. 1 in shareholder activism, while Vanguard was last.” (DFA excels in shareholder activism but passive index providers challenge management comparatively little.)

In the Canadian context in the Globe and Mail’s  “Dimensional Fund Advisors: Living up to their market-beating promise?” Andrew Hallam  quotes Booth:  “I recoil when people think that what we do is being passive, because it has nothing to do with being passive,” co-chief executive David Booth said. “We are trying to beat the market without forecasting in the usual sense.” DFA tilts its funds’ emphasis toward smaller-cap and value stocks. The firm says such stocks have outperformed the market.” (Not passive!) As to DFA Canada performance he notes that: “Most of DFA Canada’s funds have underperformed the market. But don’t write the newcomer off just yet. The past five years haven’t given us a full market cycle. The current bull runs while the next bear sleeps. We’ll see what happens after the bear wakes up.”

Commenting on smart-beta king Research Affiliates’ fundamental indexing in ETF.com’s  “’Dumb Beta’ makes a comeback” Allan Roth notes that:

 Roth: “While the “RAFI indexes” have soundly bested most market-cap-weighted indexes over several years, according to the Research Affiliates, the firm that licenses the indexes, the last 12 months have shown lags in nearly every category… Is this an aberration?  Probably, but no one knows for sure. The great debate is whether RAFI indexes eliminate a 2 percent annual drag on return vs. market capitalization weighted indexes, or is merely an efficient way to harness value and smaller capitalization factors. The former would imply free excess return, while the latter would imply compensation for taking on more factor risk.  I happen to fall into the latter camp though I think smart beta is a brilliant marketing move… (and) the fact that smart-beta based products are hot is cause for concern.  Money flowing into stocks with these factors drives up the prices and could lower future returns. When money follows the herd, things often don’t end well, and this could be true with even a very sound and efficient form of active investing.”   (i.e. getting paid for taking extra risk, but premia can’t last as money pours into a strategy)

Malkiel: as already quoted above “And in 2009, RAFI doubled the weight of bank stocks and had 15 percent of the portfolio in Citigroup and Bank of America… we were thinking that the government might very well nationalize the banks. The banks were cheap, relative to book value… But holding a portfolio that had 15 percent in a couple of stocks that were teetering on the edge was a bet that worked. But don’t tell me that that wasn’t risky… it’s the only period that he outperformed. But don’t tell me this was because he avoided overpriced stocks.” (The only period of outperformance coincided with having taken extraordinarily high risk !)

Bottom line

You need to make up your own mind, but remember that if you don’t understand it don’t buy it. If you understand it, you’ll agree that higher return comes with more risk, and as more money pours in the risk premium will like drop. I haven’t yet succumbed to the siren call of smart-beta, as yet.

If beta is the market (by definition) then smart beta, if different, is not the market (i.e. smart-beta is a misnomer or an oxymoron) and therefore is active not passive.  As to whether smart beta is an index, some call it an “active index”, because it is a  “rules-driven quantitative strategy”.

The ‘good’ delivered by smart beta includes at least: cheaper and more transparent active approach than traditional active potentially increasing the dismally small proportion of active funds capable of sustainably outperformance their actual benchmark, quantitative analysis helps with price discovery like traditional active (thus also benefiting passive index investors), when strategy is new market outperformance may be expected due to higher risk premia associated with factor tilt at least until capacity is exhausted, and DFA practices more aggressive shareholder activism. If you really want smart-beta you can get it cheaper using/blending two passive indexes (blended index)

The ‘bad’ which comes with smart beta: it is active rather than passive with accompanied historical cost drag, higher risk than market potentially less desirable by those with lower risk tolerance and/or might have to take steps to reduce overall risk (e.g. increase fixed income allocation), even when it outperforms market it doesn’t outperform it on a risk –adjusted basis, when successful the return advantage eroded by strategy’s capacity limitations, and future may be different than the back-tested past

So, with the future being unknown and unknowable, factors based strategies may come and go, but the only certain thing is the drag resulting from its frictional costs. So investing in “the market” to partake in the market risk premium at the lowest cost, should continue to be a persuasive argument that should be considered by all investors.

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2 comments

  1. A good source for smart beta stuff is EDHEC Risk Institute http://www.edhec-risk.com/

  2. Hi Jean,
    Thanks…It seems that they agree that smart beta is active…active tends to underperform compared to passive (latest interesting stats are in Buttonwood’s blog Spin the bottle http://www.economist.com/blogs/buttonwood/2015/06/investment ) …perhaps instead of “smart beta” it should be “cheap alpha”? I am still hanging tough with my plain old “beta”…
    Peter

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