A Case for Dumb Beta

“There are a lot of dumb ideas now masquerading as smart beta. My fear is that a potential crash that was hypothesized – in a few overvalued ‘smart beta’ strategies – may make the ‘smart beta’ label a subject of future jokes, and a chapter in the CFA program.” This quote comes from Rob Arnott, who is widely considered the founder of the smart beta fund strategy. His research brought the idea of smart beta into the investor psyche in 2005.

Rob ArnottSo, what exactly is smart beta and how does it work? Well, to understand it, first you should understand beta. Beta is calculated by plotting the daily returns for two securities and then creating a linear regression from that scatterplot. From the linear function that pops out, you then take the slope to determine how the returns of the two equities move relative to each other. The higher the number , the more often  securities move  in the same direction with the same magnitude. This an interesting thing to consider because the S&P 500 and the DOW Jones Industrial Average move essentially in lock step together even though one is weighted on price and the other is weighted on market cap, but that’s a story for another day. Smart beta is essentially taking a traditional fund, and then implementing slightly different weights based on fundamental characteristics or specific criteria. The goal is to take an existing product (a traditional plain Jane index fund) and tweak it slightly so that your new criteria outperform the market. What makes these “smart” beta products are that you use established rules and strategies to make decisions about the different weights of the products that you invest in.

The concept of smart beta comes from the aforementioned gentleman named Rob Arnott who co-authored a paper with Jason Hsu and Philip Moore. Their paper was on something called Fundamental Indexation and the premise described what we call “smart beta” today. Arnott is commonly considered the founder of this investment philosophy. However, smart beta wouldn’t be where it is today without the rise of ETFs. ETFs could market themselves as being “smart beta” based on their composition going forward. The introduction of ETFs also allowed several different strategies to be easily accessed by investors. You can find ETFs that start with the composition of the S&P 500, but place slightly more weight on something like free cash flow growth or dividend yields above 3.5%. The criteria can be anything. Smart beta usually relies on five different criteria to try to outperform the market. Three of the most common are:

  • Value (P/E, Dividend Yield, etc)
  • Quality (Dividend Growth Rate, Altman Z-Score, etc)
  • Momentum (Technical Analysis)

Bloomberg has found that a blend of these smart beta criteria outperformed the market from 1963 to 2015. Smart beta plays an interesting role in risk management too, as different characteristics can lead to fewer risks in your portfolio going forward. Investors can focus only on companies that have high scores on stability metrics such as dividend providing companies or companies that have a low debt to equity ratio. Another way to look at smart beta funds is to think of them as indicators themselves. If you want to invest in low P/E companies, you start with your low P/E companies but as the P/E of individual stocks rises over time, you start to sell off some of your position in these companies, and do the inverse for companies that have a shrinking P/E. The way your criteria changes determines your buy and sell decisions.

There are some doubts about the future of smart beta. For one thing,, if everyone decides to jump on the bandwagon and start purchasing these smart beta ETFs, at some point this will arbitrage away any profit opportunities because prices will rise beyond their intrinsic value. Another issue with the smart beta phenomenon is that it could be a self-fulfilling prophecy.  Investors could be flocking to smart beta products because they are thought to have superior returns compared to traditional index funds. These inflows will prop up the value of the smart beta ETF and it is hard to discern if the ETF is becoming more valuable intrinsically, or if investors are flocking to it because it is popular right now. It is possible to make the case that some smart beta ETF value comes from marketing and the institutional holders that determine buy and sell decisions for their retail investors. If you need any evidence for smart beta ETF popularity, here is the breakdown from the 69 new funds that were launched in 2016. Smart beta funds make up the largest share as creators of these funds try to capitalize on their popularity.

New ETFs Introduced in 2016

*Provided by SeekingAlpha.com*

Further, smart beta funds are prohibitively expensive. Most major ETF providers have cut their costs for these products over time, and now they are relatively cheap for your average investor to hold. Many have an expense ratio under 15 basis points. If you own one, hopefully, that fad is long lived and something you can take advantage of. Otherwise, maybe it’s time to consider putting options on your new ETF portfolio?


Sources:

Investopedia. 2017. Risk-Adjusted Return. http://www.investopedia.com/terms/r/riskadjustedreturn.asp.

Mahmudova, Anora. 2016. Pioneer of smart-beta investing warns strategy is being abused. August 11. Accessed April 7, 2017. http://www.marketwatch.com/story/the-pioneer-of-smart-beta-investing-is-flashing-warning-signs-2016-08-10.

Molla, Nir Kaissar & Rani. 2016. Is Smart Beta Investing Really Smarter? May 26. Accessed April 7, 2017. https://www.bloomberg.com/gadfly/articles/2016-05-26/is-smart-beta-investing-really-smarter.

Research Affiliates. 2017. Smart Beta. Accessed April 7, 2017. https://www.researchaffiliates.com/en_us/smart-beta.html.

Rowland, Ron. 2016. ETF Stats for April 2016: Smart Beta ETFs Surpass 600. May 11. Accessed April 8, 2017. https://seekingalpha.com/article/3973947-etf-stats-april-2016-smart-beta-etfs-surpass-600.

 

 

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