Opinion

James Saft

The “smart beta” oxymoron

December 19, 2013

Dec 19 (Reuters) – As is so often true in investments, in
the case of “smart beta” it turns out that if it sounds like an
oxymoron, it probably is.

Beta – the opposite of alpha, otherwise known as beating the
market through skill – is the return you get from market
exposure. In other words, if you buy an index fund you get beta.
Pay up for an active fund and you are betting on receiving alpha
in return.

Smart beta is a strategy which tries to improve on index
tracking returns by adjusting away from the typical cap-weighted
style, in which a given fund will hold shares or securities in
proportion to market capitalization.

Smart beta has been described as being “at the intersection
of passive and active management” which in its own way is a bit
like being at the intersection of pregnant and not pregnant. You
are either are, or are doing, one or the other, so best to be
up-front about it.

James Montier, of fund managers GMO, thinks the name smart
beta amounts to really nothing more than a bit of smart
marketing.

“Of course, investment managers have worked out that turning
up at someone’s door and saying, ‘I’ve got this brilliant idea
about how to beat the cap-weighted benchmark. I’m going to
invest in value stocks and small-cap stocks!’ would get them
laughed out of town,” he writes in a note to clients. (here)

“But make no mistake about it: that is exactly what just
about every smart beta strategy is doing.”

And indeed the marketing has been pretty successful, with
net inflows over three years of more than $80 billion, according
to State Street Global Advisors.

Citing research by Rob Arnott and colleagues from Research
Affiliates, Montier notes that most of the strategies associated
with smart beta produce portfolios which do tilt towards value
stocks and small-cap stocks. And indeed, when you adjust for
those biases, they show no statistically significant
outperformance. (here)

So what is the issue with this particular investment
oxymoron? Making an investment which is biased towards value or
small-cap stocks is fine, so far as you understand what you are
doing, what it will cost and what the risks are.

RISK IS SUCH AN UGLY WORD

First off, costs. While costs of smart beta strategies have
dropped in recent years as new entrants made the market more
competitive, the sector still benefits from a halo effect from
index investing. Index investing is dirt cheap while smart beta,
in contrast, adds some fertilizer to that dirt. Less than a
hedge fund, certainly, but more than an index fund.

The second issue is the price you will pay, not for asset
management, but for the assets you will end up owning as a
consequence of your strategy decisions. You will end up with an
enhanced exposure to small-capitalization and value stocks, both
of which are very highly valued by the market right now compared
to historical norms.

Take U.S. value stocks as expressed by the S&P 500/Barra
Value index. They are now trading on a 16.8 price/earnings
ratio, as against a 1960-1999 average of 11.2. Investment
returns run in waves, but those waves change direction from time
to time, lifting different boats in different eras.

Perhaps those high valuations will continue, maybe even
expand, but that exposure implies considerable risk. Most of the
back-testing for smart beta strategies only goes back 15 years
or so, far less than for indexing, and thus less to be relied
upon.

That is perhaps my biggest worry about smart beta – that it
is getting a bit of a free ride off of the good name of passive
investment, but may be unable over the long term to deliver what
it promises.

That’s essentially self-deception. In my experience where
you find self-deception and investors in the same room you will
also find investment managers. What you usually don’t get is
sustained outperformance over time, taking into account costs.

Maybe someone out there is adding genuine value with smart
beta, and will be able to continue to in the future but I
wouldn’t bet on it.

No matter what you do, don’t let anyone tell you it is smart
beta. It just can’t be.
(At the time of publication James Saft did not own any direct
investments in securities mentioned in this article. He may be
an owner indirectly as an investor in a fund. You can email him
at jamessaft@jamessaft.com and find more columns at blogs.reuters.com/james-saft)

(Editing by James Dalgleish)

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