Forget Smart Betas: Step Up to Smarter Betas

Friday, November 08, 2013 19:44
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Forget Smart Betas:  Step Up to Smarter Betas

Tags: alpha | indexing | smart beta

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.     
 
 
Conclusion
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.     

Comments (6)

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rickferri
Rob Arnott did not coin the phrase “Smart Beta.”

He latched onto the marketing spin when he first heard the phrase and has not let go.
rickferri , November 11, 2013
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rickferri
Your idea that fundamental weighting is a free lunch is flawed. Arnott himself will tell you that the higher expected returns are result of taking higher risk in a portfolio.
rickferri , November 11, 2013
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ronsurz
Interesting about Arnott. Thanks Rick.

I never said "free lunch", & I haven't seen Arnott say it's a return to higher risk. What is true though is that fundamental indexing is based on a historical observation that might not continue into the future. It is not cast in stone that small cap value will win.

ronsurz , November 11, 2013
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rickferri
That is definitively true, Ron. There are three facts about factor investing that is always true, 1) it is more expensive that beta investing, 2) all strategies are based on past risk premiums in the market, meaning it is payment for taking extra risk in a portfolio, 3) there is no guarantee these risk premiums will exist in the future. Full disclosure, I use factor investing in my portfolio. You won't find me calling it "smart beta" though. I would rather call it by what it is.
rickferri , November 12, 2013
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ronsurz
Works for me Rick. Are you familiar with Bob Haugen's work? He was a friend of mine.
ronsurz , November 12, 2013
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rickferri
That was a flash from the past. Yes I am. I have one of his books.
rickferri , November 13, 2013

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