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Is 'Smart Beta' Just a Fancy Word Trick?

By: ETFguide
Posted: 12/5/2013 5:05:00 PM
Referenced Stocks:

Are 'smart beta' strategies really a new and better  breed than competing investment strategies or just an innovative word trick for something else?

James Montier, a member of GMO's asset allocation team observes:

"When these strategies are corrected for their exposure to 'value' and 'small,' they exhibit no statistically significant outperformance compared to the cap weighted benchmark. In other words, the fact that smart beta has outperformed has nothing to do with the story told (i.e., better covariance matrix, exploiting index hugging, or contra trading against the cap weighted benchmark), it is simply that they embed exposure to value and small, two traits known to have outperformed over time."

"Smart beta strategies are at the intersection of active and passive investing. Their goal is to beat the market using a rules based, transparent, low-cost approach," says Research Affiliates.

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Smart beta strategies in the investment world generally fall into two camps: 1) Indexes that use a one-dimensional or simple formulas, like equal weighting all the stocks within a benchmark like the Guggenheim S&P 500 Equal Weight ETF (NYSEARCA:RSP) does. Or, 2) Weighting stocks within a portfolio using a multiplicity of complex factors like book value and cash flow, as does the PowerShares FTSE RAFI US 1000 Portfolio (NYSEARCA:PRF).



Smart beta's goal is to outperform traditional market cap weighted indexes and active managers. In less sophisticated circles, this is just known as "beating the pants off of everything."

ETFs that weight companies by dividends like the WisdomTree Large Cap Dividend Fund (NYSEARCA:DLN) or the iShares Select Dividend Fund (NYSEARCA:DVY) are other offshoots of the smart beta movement, despite their singular focus on dividends.

Over the past five years, PRF and RSP have handedly outperformed the S&P 500 (NYSEARCA:SPY) and other cap weighted benchmarks linked to large company stocks.

But even with impressive historical performance by smart beta indexes comes a notable admission.

"Seen from another perspective, the smart beta strategies inherently have value and small size tilts relative to cap-weighted benchmarks," notes a 2011 paper by Chow, Hsu, Kalesnik and Little. Isn't that essentially the same point Montier, a critic of smart beta, makes? Wouldn't this point also make smart beta strategies essentially an old concept but in entirely new packaging?

Furthermore, can't investors simply tilt their portfolios to overweight small cap and value stocks with corresponding funds, rather than relying on a smart beta ETF to do it for them?

Another issue deals with whether smart beta strategies, which have been optimized in a financial laboratory, can replicate that same type of historical success in the real world. Regardless of how long a smart beta strategy has been backtested, the real test is how it performs in the future.

"Smart beta is an impressive branding story. Investors should question the labels and recognize the emotion that may be involved in the narratives, said Colin McLean, a writer for the CFA Institute's blog.

Sounds like pretty smart advice for even the dumbest of people.  

The ETF Profit Strategy Newsletter uses technical, fundamental, and sentiment analysis along with market history and common sense to keep investors on the right side of the market. Since the beginning of the year, 74% of our weekly ETF picks have been winners. (through Q3 2013)

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