Smart Beta: Silly Talk?

In a 2013 Forbes article, “Smart Beta is Silly Talk,” author Rick Ferri states:

Though the article was written more than a year ago, smart beta’s name continues to be surrounded by as much confusion today as then. The important question that needs to be answered is whether this new catchphrase is helpful to investors seeking to understand the best investment strategy for their particular situation. 

As with any word in the English language, it helps to consider the origin of the term as well as the way in which its meaning has changed over time. In the case of smart beta, it is also helpful to consider (or better yet, to challenge) some of the assumptions surrounding the current usage of the term. This helps to shed light on the confusion that the term creates.

As reported in the Forbes article: 

Watson Wyatt, the firm which first introduced the term, defines “smart beta” as  “strategies that move away from market-cap indexation in traditional asset classes” versus “bulk beta,” which they define as “traditional market cap passive investment in core asset classes such as equities and bonds.” 

The introduction of smart versus bulk beta created a helpful conceptual framework to begin to think differently about traditional indexing strategies. However, some would argue that this shift from conceptual framework to marketing catchphrase is creating more confusion than clarification.

To define smart beta beyond just being a price-weighted stock and bond index is challenging to say the least. A critical examination of some of the assumptions that can be found in much of the investment industry literature helps to illustrate the definitional challenges of smart beta.

Assumption: Smart beta is a superior form of indexing.

Counterview: The use of the term “smart” implies that the opposing product or service is “dumb.” Presumably, this would imply that bulk beta is dumb and, conversely, smart beta is, well, smart. This can certainly be an appealing marketing strategy. However, it is just that — applying a label to make something more attractive. Nonetheless, to simply apply the label “smart” does not, in and of itself, mean that it is so. What is known is that price-weighted securities reflect what the investment-buying community at large believes securities are worth at a given point in time. Some would argue that the price-weighted approach to indexing is the one which is most closely aligned with the “efficient market hypothesis” and, thus, is the smartest way to invest. Others would argue that there is no smart way to invest at all times since investment strategies fall in and out of favor — something that is tied to market cycles more than anything else. Thus, no investment strategy should bear the “smart” label.

Assumption: Smart beta is where active and passive meet.

Counterview: It can be argued that since price-weighted indices (often referred to as bulk beta) and book-weighted indices (often referred to as smart beta) both follow rules that are independent of any further analysis of the individual securities beyond these "factors," they are both equally passive. There is no combining of passive and active strengths, just different sets of rules being applied to create different types of passive funds.

Assumption: Smart beta is a relatively new investment strategy.

Counterview: In the mutual fund world, what some have termed as smart beta has been around for more than 30 years, with the biggest pioneer being Dimensional Fund Advisors and other firms such as Research Affiliates. The new twist is the proliferation of mostly ETF products that are being referred to as smart beta. Interestingly enough, it is more often the case that it is the advisors and industry pundits who are using the term, not the mutual fund or ETF manufacturers themselves.

Assumption: Smart beta strategies involve more trading of underlying securities, which drives up internal expenses.

Counterview: A chief benefit of some smart beta strategies is that they are based on custom versus commercial indices. Commercial indexes are mostly judged on their ability to avoid tracking error. Any money manager, when making a trade, wants to be a liquidity provider as opposed to being in sudden need of liquidity. The former is much more likely to come out ahead on spread costs. Managers of commercial indices, in order to avoid tracking error and from the standpoint of spread costs, must trade whether the timing is good or bad. On the other hand, when managing a custom index, traders can be both patient and selective when trading underlying securities. Given that internal trading costs are often higher than external fees, this can be a significant cost advantage for a manager of a custom index over a manager of a commercial index, thus driving down overall trading costs.

Assumption: Smart beta should cost more than bulk beta because it is somewhat active.

Counterview: If both smart beta and bulk beta are managed based on a stringent set of rules, then theoretically they should cost about the same. No managers of either strategy are poring over analysts’ reports or questioning CEOs about growth prospects or CFOs about financial forecasts. Rather, both types of managers are simply applying rules about what to buy and sell based on a predetermined formula, be it a price-weighted or book-weighted orientation or any other “factor” (e.g., company size, style box) that is used to tilt a passive portfolio in a particular direction. The fact is that the price focus should not be based so much on what a manager charges (assuming it is within reasonable limits) as it should on what the manager is delivering in terms of return. If their particular rules-based formula results in a consistently higher return, then they will be able to garner a higher price in the market. In short, money managers base what they can charge on what the market will pay, not on a cost-plus basis.

The world of investing is challenging enough as it is for plan advisors and, especially, plan sponsors. The more crisp and precise that the “industry speak” can be, the better. To that end, smart beta is not helpful in that it does not fit logically into the otherwise mostly binary terms that dominate the terminology describing investment styles today — if for no other reason than it does not have a binary partner term. “Dumb beta” must be ruled out and “bulk beta” is simply too disparaging when matched up against “smart beta.” 

It seems that the term “smart beta” creates a grey area when none is needed. A money manager is either “active” and picks individual securities based on how they are projected to perform despite having the same “factors,” or is “passive” and selects securities on an equal basis based on factors they share with other securities. (Whether Steve Jobs runs Apple, or whether Android is a threat to iPhone’s market share, are not investment “factors.”) Either index managers utilize a commercial price-weighted index (which is closest to how the market values individual securities) or they utilize a custom/tilted index, which assumes that the actual price of an index is not truly reflective of its market value. 

Finally, the fact that the author of the term “beta,” Bill Sharpe, has stated that the term “smart beta” makes him “definitionally sick” speaks volumes about whether this term should be stretched beyond its use as a conceptual framework to think about indexing (as originally intended) as opposed to a means to augment selling investment strategies (as is now often the case). In short, to throw into this mix the term “smart beta” seems to create unnecessary confusion and is not helpful for those seeking to understand the salient features of the myriad investment strategies from which they must choose.