Fads and fashions have always been part of the financial markets. Around the turn of the century Internet-related stocks were regarded as reliable instruments for growing and preserving wealth. During the early 2000s, real estate was the instrument of choice for savvy investors. Today “Smart Beta” is the mantra of legions of securities salesmen who claim that broad-based low-cost index funds are sub-optimal and that better results can be obtained by biasing portfolios toward a number of characteristics that promise higher returns.
There is no universally accepted definition of “Smart Beta.” What most people using the term have in mind is that it may be possible to gain excess (greater than market) returns using a variety of relatively passive investment strategies; strategies involving no more risk than would be assumed by investing in a low-cost total stock market index fund.
If an investor buys a low-cost total United States stock-market index fund, she will receive the market rate of return as well as assume the characteristic ups-and-downs risk of the U.S. stock market. Remember that the volatility of the market is measured by Beta and that the Beta of the market is defined to have a value of one.
Now what the “Smart Beta” investment managers would have us believe is that pure indexing, where each company has a weight in the portfolio commensurate with the size of the company’s total capitalization (its number of shares multiplied by its market price), is not an optimal strategy. Proponents of “Smart Beta” strategies claim one doesn’t have to be a stock-picker, as most active portfolio managers are, to be able to beat the market. Rather, you can manage a relatively passive (low turnover) portfolio to accomplish good results more dependably without assuming extra risk. The trick is to tilt the portfolio in some direction such as “value” (low price/earnings and low price/book value) versus “growth,” smaller companies versus large, relatively “strong stocks” (those doing better than the market) versus weak, “low volatility” (more stable) stocks versus “high volatility” (less stable) ones.
“Smart Beta” strategies rely on a type of active management. They are high cost and tax inefficient relative to traditional index funds and none have reliably and consistently beaten the market.
Over the past 100 years the returns from smaller companies have exceeded those of larger companies. It is also true that stocks with low valuations (i.e. lower prices relative to earnings and book values) have generated better returns than those with high valuations. What is less certain is whether these tendencies will continue in the future and if they do are they really superior returns or rather proper compensation for investors willing to assume greater risks? Moreover, can the additional returns apparent in simulations of historical records be achieved with real money or will they be eaten away with higher transaction costs, higher taxes, and higher fees?
Why “Smart Beta” Funds May not Be Smart Investments
The case for investing in “Smart Beta” funds is based on simulations of historical stock market returns. But there are serious questions concerning the wisdom of investing in these funds as opposed to the traditional capitalization-weighted funds used in the Wealthfront portfolios.
Never forget that capitalization-weighted funds are the market. All the stocks in the market are held by someone and investing must be a zero-sum game before costs. If you invest in a subset of securities that produce above-average returns, it must follow that some other investors are holding stocks that produce lower-than-average returns. If you believe that you are smarter than the collective wisdom of thousands of professional investors who dominate trading, keep in mind that you are counting on some dumb investors to give you an edge.
There are now large numbers of Smart Beta mutual funds and ETFs. Their record over the past five to 10 years has been decidedly mixed.
Some “Smart Beta” advocates have been quite explicit in suggesting who these dumb investors might be. They claim that the investors in traditional capitalization index funds are the dumb beta investors, since, by holding the broad index they will be holding a number of overvalued growth stocks. But that argument must be false. The holder of a broad-based index fund will by definition achieve the average. In the presence of costs, investing has to be a negative-sum game. The broad market portfolio can be accessed through ETFs at very little cost. “Smart Beta” funds and ETFs charge annual fees that can be a very large multiple of those charged on standard capitalization-weighted index funds.
Some of the factor-tilt portfolios (meaning a tilt toward size or value factors or in the case of multi-factor portfolios, more than one) assume considerable risk relative to capitalization-weighted portfolios. For example, coming out of the financial crisis in 2009, portfolios with a value tilt substantially over-weighted in large bank stocks often sold at universally large discounts from their book (asset) values. The RAFI “Fundamental Index” portfolios had about 20% of their portfolios in these stocks (Citigroup and Bank of America among others) at that time. It turned out that such an overweighting helped produce excellent returns. But it was far from clear at the time that the banks would avoid nationalization and many observers were calling for a “zeroing out” of the stockholder equity. In any event, the strategy involved considerable risk. So a few points to keep in mind about “Smart Beta” strategies:
- All of the “Smart Beta” portfolios have long periods in which they underperform. “Momentum” focused portfolios underperformed during the first decade of the 2000s. “Value” underperformed from 2000 through 2009. Small stocks underperformed from 1984 to 2001. Over the past three years, low-volatility strategies have been outperformed by capitalization-weighted index funds.
- Even during periods when a factor tilt appears to have produced substantial excess returns, those returns may not be achievable with real money portfolios.
- Real money portfolios incur transaction costs and rebalancing costs that can be substantial.
- Real money portfolios incur expense ratios that are considerably higher than passive capitalization-weighted index funds. (Note: Equally weighted portfolios typically produce much larger returns than cap-weighted portfolios in simulated tests. The actual returns of such portfolios run with real money are considerably smaller.)
Smart Beta funds require periodic rebalancing; for an equally weighted fund to maintain its weighting, stocks that have gone up more than the average market return must be paid back. In a rising market trading involves transaction costs and will trigger short-term capital gains taxes and is therefore very tax inefficient. Cap-weighted funds automatically rebalance without the need for any trading. Hence standard index funds tend to minimize both transaction costs and taxes and thus are very tax efficient.
“Smart Beta” funds and ETFs charge annual fees that can be a very large multiple of those charged on standard capitalization-weighted index funds.
Suppose a factor tilt was discovered that appeared to be effective and not based on the assumption of extra risk. You can be sure that more funds would be created to exploit the finding. If investors then poured money into the new Smart Beta fund it’s quite possible that the fund would cease to produce extraordinary returns. It has frequently been the case that when some new “anomaly” or predictable pattern receives considerable publicity, that the irregularity ceases to exist. This is likely to be especially true if the pattern results from some behavioral bias. Only if the pattern results from the factor representing extra risk should it persist. Other patterns resulting from investor irrationality are likely to be arbitraged away.
Finally, many of the “Smart Beta” ETFs are more costly to buy and sell than their traditional cap-weighted brethren. Plain vanilla S&P 500® index funds trade at prices essentially the same as their net asset values as any differences tend to quickly be arbitraged away. Many “Smart Beta” ETFs tend to follow nonstandard indexes that are often difficult to hedge against. Hence their prices are far more likely to deviate from face value and often trade at significant premiums or discounts from the value of their underlying holdings.
What is the Recent Record?
There are now large numbers of Smart Beta mutual funds and ETFs. Their record over the past five to 10 years has been decidedly mixed. Whole “value” funds did very well in the early years of the 2000s when the dot com bubble popped; they have done worse than the overall market average since 2005. Small capitalization funds have over-performed large-cap funds over the past decade but performed far worse during the first five years of the 2000s. These funds also assumed considerably more risk than capitalization-weighted regular index funds.
Funds that indirectly impart a size and value bias to the portfolio have slightly exceeded the returns from cap-weighted broad-based funds and ETFs but they took on considerably more risk and were less tax efficient. It is interesting to note that “size” effect has been measured since 1926 and “value” since 1960 though the latter is not always present. Neither momentum funds nor low-volatility funds have outperformed the broad stock market indexes that form the basis for the Wealthfront portfolios.
In sum, the records of “Smart Beta” funds and ETFs have been spotty. They do not, as a group, produce reliable excess returns although a few have beaten the market over the timeframe of the funds. When they have generated greater than market returns, these excess returns should be interpreted as a reward for assuming extra risk. “Smart Beta” portfolios do not represent a sophisticated better mousetrap for investors and investors should be wary of getting trapped in the new mousetraps themselves.
Implications for Investors
“Smart Beta” strategies rely on a type of active management. They are high cost and tax inefficient relative to traditional index funds and none have reliably and consistently beaten the market. As recent research and commentary from Vanguard Group puts it “Smart Beta” strategies are often, “active bets and not substitutes for traditional index funds.”
“Smart Beta” portfolios are more a testament to smart marketing rather than smart investing. We believe that the broad-based low-cost capitalization-weighted index funds that make up the core of the Wealthfront portfolios will give the investor the most prudent trade-off between risk and return available and the most predictable and tax-efficient way to manage and grow your wealth.
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