The Financial Times Lexicon defines “smart beta” as “an umbrella term for rules-based investment strategies that do not use the conventional market capitalization weights that have been criticized for delivering sub-optimal returns by overweighting overvalued stocks and, conversely, underweighting undervalued ones.”
There are those who agree with the above definition and others who believe that it is a nonsensical term. Rick Ferri, founder of Portfolio Solutions and author of six books on indexing, considers the term "silly" and “insulting.” "Beta is just beta," according to Ferri.
Perhaps this view is correct and beta is simply beta any way you slice it. Where is it written in stone that because an index is price-weighted and based on a commercial index (e.g., the S&P 500), one is “smart” and the other is, well, “dumb”? Are smart beta investment managers simply using different criteria (i.e., rules) for creating an index? Does making the break away from price-weighting create an entirely new type of beta?
Some investment managers go even further, saying that “beta is just beta” and taking the position that smart beta could be “the worst of two worlds.” One rationale is that the “smart-beta approach may fall between these two options [i.e., passive/active], with a fee disappointingly close to the active manager and no clarity on the outcome,” a Financial Times article notes (site registration required).
The lack of a clear definition and some bad press regarding a few of the strategies has not stopped smart beta from growing quite rapidly. In the ETF realm, smart beta strategies grew by 43% versus 19% for ETFs overall in the first nine months of this year. Furthermore, according to a CNBC report, advisors “are extraordinarily enthusiastic about [smart beta ETFs].”
Given the increasing shift toward passive investing within DC plans, plan advisors should consider how to respond to the challenge of both defining what smart beta is and determining its overall efficacy as an alternative to active investing and price-weighted indices. And, according to how one defines beta, another consideration is whether it deserves an elevated class within the world of beta — and the higher price tag that goes with it.
