Smart beta looks good on paper but is it all it seems? Jeffrey Molitor, chief investment officer, Europe, at Vanguard Asset Management, thinks not.
There is considerable swirl in investment circles regarding the concept of ‘smart betas’. What is a smart beta? Is it analogous to a ‘smartphone’ – a breakthrough that is easy to use and makes life better by expanding the ability of individuals to communicate and access a wide range of information on the fly? The short answer is no.
Beta, most simply, is the aggregate opportunity set for a given asset class. In reality, smart beta investors are buying a strategy that simply overweights and underweights specific factors or characteristics of a particular market. It is, therefore, an active strategy, not beta.
At the same time, the word ‘smart’ suggests the market segments these strategies emphasise are somehow consistently superior to the rest of the market. We know from experience that expectation is not true. In this sense, smart beta is neither smart nor beta.
Why 'smart beta' is neither smart nor beta
‘Active’ by another name
Even though the name suggests otherwise, smart beta is an active investment strategy that deliberately deviates from market-cap weightings, usually with the goal of generating alpha.
As with all active strategies, there is no assurance that a smart beta method will work. All you know is that it will likely cost more than a pure beta strategy.
Investors usually take comfort in back-tested results provided by the purveyors of smart beta. Unfortunately, looking backwards does not tell you what is around the next corner.
What is more, disappointing back test results never see the light of day. It should not be surprising, therefore, that smart beta looks good on paper.
Investors must also recognise that with smart beta they take on active risk – a risk that is required in order to beat the benchmark. Smart beta funds have inherent and deliberate biases by de-emphasising certain market factors and emphasising others instead.
However, by definition, no particular strategic bias is permanently in favour. In order to use smart beta successfully, investors may need to rotate from one smart beta strategy into another in order to gain exposure to whichever risk factors they think will be rewarded next. But how many investors have the foresight to know which factors will be in and out of favour, and when?
Winning is about not losing
In his book Winning the Loser’s Game, Charley Ellis argues that, like tennis, successful investing is more about not losing than winning. Many smart beta investors are likely playing a loser’s game.
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