Smart beta is a popular disguise on Wall Street this Halloween. But don’t be fooled into believing these strategies are really that smart.
The term “smart beta” has been used to describe a number of investment strategies, all of which share a common denominator: they diverge in some respect from a market-capitalization weighted benchmark. Smart beta strategies attempt to beat the market by ignoring market prices and, instead, altering the weights of the stocks within a given benchmark.
Purveyors of smart beta products often claim to deliver returns that are like the market—that’s where the term beta, widely associated with indexing, comes in—but only better. In the words of Vanguard researcher Joel Dickson, “smart beta is what you get when you host a Halloween party and an active manager comes disguised as an index fund.”
In independent research papers, researchers at both Dimensional Fund Advisors [1] and Vanguard [2] showed that the excess returns promoted by those selling smart beta strategies can be largely explained by two well-known drivers of returns: increased exposure to low-priced (“value”) and small-cap stocks.
In this respect, at least, smart beta doesn’t look too scary. Smart beta strategies tend to be lower-cost than other toxic Wall Street creations of the past, are somewhat diversified, and at least bear a partial resemblance to a market-based portfolio with tilts toward small cap and value stocks.
What we find most interesting, however, is the hidden message in Wall Street’s sudden affection for smart beta: a tacit approval of indexing, in general, and, more specifically, the academic research highlighting the impressive returns of small cap and value stocks.
In other words, Wall Street has moved in our direction (now that’s a scary thought!) But, don’t be fooled: next Halloween, they’ll undoubtedly knock on your door disguised as something else.
[1] Singh, Bhanu and Marlena Lee. “Smart beta.” January 2015.
[2] Philips, Christopher, Donald Bennyhoff, Frances Kinniry, Todd Schlanger and Paul Chin. “An evaluation of smart beta and other rules-based active strategies.” August 2015.