Abnormal Returns is on hiatus this week. However that does not mean that we are content-free. As we have done in previous years we asked a panel of highly respected independent finance bloggers a series of (hopefully) provocative questions. Yesterday’s edition focused on the future of robo-advisors. Below you can see the blogger’s name, blog name and Twitter/StockTwits handle. We hope you enjoy these posts as we do.
Question: 2014 seems to be the year of ‘smart beta’ ETFs Is this simply a bull market phenomenon? Are smart beta ETFs taking the air out of the actively managed ETF space? Are they worth the effort for the majority of investors?(Answers in no particular order.)
I prefer factor investing to smart beta. There are lots of similarities between the two ideas but some important differences as well. The next real correction or bear market will take a lot of wind out of the sails of the smart beta movement.
Like the Robo Advisor phenomenon, “smart beta” looks like a lot like an attempt to take a so-called “passive” approach and sell it as something superior than buying the aggregates (all in the process of charging higher fees for a supposedly passive portfolio). I have a hard time seeing the real value add here. There’s value in some active management approaches, but I am not convinced that minor alterations in broad indices is the way this is best achieved.
I’ll repeat some comments I made from an interview I did with Samuel Lee at Morningstar.
“We think there really isn’t a true active manager in the ETF space today—you either find passive or closet passive, such as so-called smart beta. We are explicitly avoiding indexing and quasi-indexing approaches. We want to be a genuine high-tracking error, index irreverent, high expected value-add active asset manager, exploiting mispricing caused by a combination of behavioral bias and limited arbitrage. The key differentiation between us and traditional active managers is we want to deliver affordable active management, as opposed to overly expensive active management, which is the status quo among mutual funds and hedge funds. I want to make my Ph.D. dissertation advisor—Eugene Fama—proud to support active management by making it affordable.”
Bottomline: There isn’t a TRUE active manager in the ETF space…yet.
Smart beta involves smart marketing, for sure (as James Montier pointed out). The results for the strategies would likely have been cyclical without all of the attention and money thrown at them. Now, I’d bet the excess returns will be chiseled away by the hype and capital. Happens all the time.
I have not yet reached a firm conclusion. It makes sense to proceed carefully, understanding how a particular investment fits your entire program. We will know more when there is a longer history.
The basic concept of “smart beta” in the context it was first presented – Rob Arnott’s “RAFI” Fundamental Indexes – was an alternative way to gain exposure to the broad markets (i.e., beta) and to do it in a manner that Arnott dubbed “smarter” (by using fundamental weightings instead of market-cap weightings).
But what should have remained simply a debate about whether fundamental indexing was “smart” or not, has morphed into a world where the “smart beta” label has been adopted – or rather, over-adopted and co-opted – to represent virtually any investment strategy that involves a rules-based methodology to weight investments (and even then, there’s no consistent ground rules in defining what ‘smart beta’ is in the first place). It seems more and more often, ‘smart beta’ is little more than a way to represent an active or tactical investment management strategy as something more ‘indexed’ than it really is, as the term has become co-opted into a dizzying array of marketing uses.
Notwithstanding the perhaps questionable use of the word ‘smart’, Arnott did have and continues to have an interesting point about whether there is a systematic flaw in weighting stocks in a market index based on market-cap rather than alternative fundamental weightings. But at some point, we seem to have forgotten that the whole point of “beta” is that it starts with the market portfolio in the first place, not narrow slices of active management strategies that deviate from the market portfolio in pursuit of alpha!
“Smart beta” is really smart marketing, but I think there’s value there too (even if four – or five – factor investing gets to the crux of it pretty well).
Factor investing has a chance to really take off as active mutual fund companies try to work their way into the ETF/passive investing space. But most new investors to these funds only see the back-tested long-term results and fail to realize that they are very cyclical and go through long stretches of relative underperformance.
Unfortunately, most long-term investment strategies are bull market phenomenons for certain investors so there will be casualties along the way for those that don’t have the required patience and discipline to see these through a full cycle.
It will also be interesting to see if the historical premiums for value and size eventually decrease because of an increase in these types of funds and a more widespread knowledge of their existence.
If you want extra exposure and want to ramp up your risk profile, I’d prefer purchasing a sector of stocks. Or, learn how to trade options. Option trading is finally coming into its own. It’s where the future is and how average investors can tie the HFT’s into knots and get the Greeks working for them.
‘Smart beta’ is an annoying term because it covers too many strategies—from fundamental indexing, to low volatility, to high momentum—that will deliver VERY different returns from one another. As such, it is hard to evaluate as a category. Versions of smart beta that look very similar to market-cap weighted indexes (sometimes called closet indexes) may not be worth the extra fees and higher tax impact. But those that build distinct portfolios using proven factors like value, momentum, yield and quality deserve the attention that they will continue to garner. Sadly, while these more concentrated strategies will likely work in the long term future as they have in the past, investors will probably abandon them (at exactly the wrong time) following inevitable periods of prolonged underperformance.
I always get this wrong. Which one is it that we want, the beta? Or is it the alpha? When I was growing up there was a supermarket near my house called Alpha Beta. It didn’t have anything to do with finance but they had the cheapest beer in town and didn’t check ID’s. Investors should drink more often.
Markets continue to find new ways to provide exposure to risk factors in a cheap/liquid manner, and I think this will continue. Just wait until securitization comes back…
Thanks to everyone for their participation. Stay tuned for another question tomorrow.