How smart is Smart Beta really? Does it depend on Dumb Beta staying dumb and never wising up?

Those lucky enough not to speak fluent financial jargon could be excused for not understanding these sentences. But they cut to the heart of the debate over how to attempt to beat the stock market.

Beta, in this sense, is a term from capital asset pricing. It is a coefficient that captures the extent to which a stock is sensitive to the market. A stock with a beta of 1 moves exactly in line with the market at all times. The market itself has a beta of one. (Alpha is the variable that captures all market moves that cannot be explained by the market).

So in financial parlance, you can buy beta very cheaply by buying an index fund. Meanwhile alpha is elusive and comes at a price. This justifies the rise of passive index funds and exchange traded funds. They give you beta, cheaply.

But index funds are dumb, accepting prevailing valuations unthinkingly. So why not offer index-like fund management that works automatically, and so keeps costs down, while exploiting anomalies in stock valuations to try to beat the index? Variations include weighting stocks by earnings, or dividends, or their risk – all measures designed to buy more stocks when they are undervalued.

This is what “smart beta” means, and it is flavour of the month. Index providers such as Russell and Standard & Poor’s now offer smart beta indices. Big institutions offer smart beta funds.

But does it work, why does it work, and how long can it keep working?

‘Definitionally sick’

The most trenchant critic is the Stanford University economist Bill Sharpe, who won a Nobel Prize for his work defining the concept of beta. He says smart beta makes him “definitionally sick”. He reasons that smart beta strategies are either factor bets – betting on cheap or small stocks to outperform – or an active attempt to beat the market (which would class them as “alpha” not “beta”).

Critically, he argues that smart beta providers cannot argue that their approach will work if everyone does it. Logically, they rely on “dumb beta” staying dumb, buying stocks that smart beta providers sell, and never learning that cheap and small stocks tend to outperform.

Mr Sharpe adds that if smart beta is really only exploiting others’ stupidity, the anomalies it exploits will be eliminated over time. So smart beta is merely an effective strategy for the moment, whose performance will dwindle over time; not a true “beta”-like exposure to the market.

In response, smart beta providers are producing research showing their strategies win not because of factors such as value, that will be arbitraged away over time, but because of rebalancing. Put simply, any strategy that regularly buys losers and sells winners will do well.

Intech, a subsidiary of Janus, calls this the “rebalancing premium”, and has managed money on this basis for some 25 years. It holds that rebalancing can be mathematically shown to produce a premium that is enduring. Even when everybody understands the value effect, rebalancing will still enhance returns.

Similarly Research Affiliates, a well-known smart beta provider, found that a portfolio of high volatility stocks and its inverse, of low volatility stocks, both beat the index by some 2 per cent per year – providing they were regularly rebalanced.

Equal weight

A further question also suggests that active managers should not be compared in any case with market cap-weighted indices, where the largest stocks have the greatest weight, but with equal-weighted indices, where all have the same weight. The latter naturally need to be rebalanced regularly. The former do not.

Researchers at S&P Dow Jones Indexes suggest that equal-weighted indices are the natural benchmark for an active manager, and not cap-weighted indices. They argue that the latter measure the performance of the average dollar or pound invested, but the former measure the performance of the average stock. Active managers do not weight their own portfolios according to market cap, so equal-weighting is a better benchmark.

The S&P 500 equal-weighted index, which is rebalanced once a quarter, turns out to be a tougher benchmark. It has beaten the S&P 500 itself by 1.2 per cent per year over the past 12 years. So this is not only a better yardstick for managers, but also a harder one for them to match.

So maybe smart beta does have a sustainable advantage, but as it lies in trading, which costs money, it may be hard over time to outperform after costs.

The worst news is for active managers. Their fees seem ever harder to justify. This should be worrying: without them, anomalies would go uncorrected and, in theory, markets should be more inefficient.

But Mr Sharpe, who believes active management is futile, has some solace. “I used to worry: what if there’s too much indexing? But human nature means people keep on backing active managers.”

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