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Bucket of Cold Water Dumped on this Investing Strategy

investingPoor Greece. Not even the Greek alphabet has been given safe quarter these past weeks. Perhaps it is the ever increasing popularity of ETF strategies and the continuing underwhelming performance of active managers, but one thing is clear if you are trying to sell an investment product: it is best to couch it as an indexing strategy. A “beta” strategy is a fancy term for saying an index strategy. “And why stop there?” asks the marketing director. “Let’s add the word smart in front of beta.” Hence we arrive at a “Smart Beta” strategy. Unfortunately, these ultimately end up being dumb alpha products that play to consumers current investing tendencies.

The strategies referenced in this article attempt to better capture market returns by moving away from actual market prices as a way to determine their buy list. A market index, such as the S&P 500, is market-cap weighted, meaning the larger companies are greater represented in the index. Many of these smart beta strategies choose an equally weighted approach (every stock carries the same percentage representation).

Under the hood, these products are simply over-weighting to value and size premiums under the guise of “smart beta.” As an example, the charts below represent a market-cap weighted representation of the US stock market broken out by asset classes (think traditional index funds)  and an equal-weighted view as used by the smart beta folks.

(LV= Large Value; LG= Large Growth; SV= Small Value; SG= Small Growth.)

Market Cap Weighted
Market-Cap Weighted
Equal-Weighted
Equal Weighted

Effectively, a “smart beta” portfolio is just a very inefficient way of creating a blended market index with risk factor exposures to size and value. In our view, it is much more effective to capture these asset classes (i.e., market-based risk factors), with specific asset class funds that use a market-weighted approach for each sector. Price is important.

As a further example, the graph below plots the investment performance of simply blending a Large Cap and Large Cap Value Index with an equally weighted index strategy. As you can see, the plot is as close to 1 as you can get. Translation: there is nothing to these smart beta strategies.

 

investing

Ultimately, market prices reflect the expectations of all market participants, and to ignore that is simply dumb.

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