Smart betas might succeed in beating the market, but so might smarter betas also, plus smarter betas complete active managers.
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Kudos to Rob Arnott for coining the phrase “Smart Beta.” Everyone wants to be smart. Indexes that use fundamental weightings, rather than capitalization weightings, are deemed to be smart by Mr. Arnott because they are predicted to perform better. For the first time ever, we have indexes that are designed to outperform. All other indexes are designed to match the performance of an entire market or a market segment.
Fundamental (smart beta) weights typically tilt toward value and smaller companies relative to their cap-weighted counterpart, and this tilt has a track record of performing better, so it may indeed be smart. Fundamental indexes are usually created for broad markets, like the U.S. or Europe and have attracted several hundred billion dollars in last few years.
Even Smarter Betas
Because smart beta indexes cover entire markets, they are not intended to be used in conjunction with active managers. If smart beta indexes were used in conjunction with active managers they would dilute active manager decisions by adding stocks active managers don’t want to hold. Furthermore, they would tilt the entire portfolio toward smaller company value, potentially undermining portfolio structure, especially growth allocations.
Complementing active managers requires an even smarter beta, an index that works best in core-satellite portfolio structures. This smarter beta works better than smart beta, which in turn works better than standard cap-weighted indexes like the S&P500:
Smarter Beta is smarter than Smart Beta is smarter than the S&P500
The smarter beta index is created by identifying the stocks that lie in between value and growth – the stuff in the middle – and by allocating to them using fundamental weights rather than capitalization. The stocks in the middle are organized into economic sectors like technology and utilities, and assets are allocated to these groups at market weights. This avoids any sector bets. Then within sector groups, each stock receives an equal allocation, which is fundamental weighting.
The result is better diversification and higher returns, which is a promise you should question. Better diversification is achieved by adding stocks that active managers usually don’t hold because they don’t fit value or growth mandates. Higher returns result if you replace an existing core with the smarter beta core because smarter beta core does not dilute active managers. This higher return expectation is based on the belief that the active managers actually add value, which seems right since they wouldn’t be hired if that wasn’t the belief.
Sometimes a good idea has its limitations. Smart betas don’t belong alongside active managers. Smarter betas are required instead. Or put another way, if your investments are entirely passive, smart betas hold the prospect of doing better than a capitalization-weighted market proxy. But if you use active management, smarter beta is what you need.