Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 94

The potential of smart beta

By the early 1970s, finance literature had already documented that the average mutual fund consistently underperformed the market index, net of fees. The literature also demonstrated that a diversified ‘market’ portfolio would naturally earn a positive equity risk premium without the help of a skilled stock picker. Armed with these academic findings, Paul Samuelson (‘Challenge to Judgement’ 1974, p. 18) challenged investment practitioners to consider creating investment portfolios that track the S&P 500 Index.

Samuelson’s short article struck Jack Bogle (‘Lightning Strikes: The Creation of Vanguard, the First Index Mutual Fund, and the Revolution It Spawned’ 2014, p. 42) “like a bolt of lightning”. Recounting the early history of Vanguard, Bogle identifies Samuelson’s challenge as a major impetus for the creation of the first index mutual fund. Vanguard’s low cost index funds, to me, were born out of a deep awareness of the academic literature and a deeper concern for the welfare of the end-investor. Nothing in our industry has so inspired me.

As a champion of smart beta and a spokesperson for Research Affiliates, which regularly debates Vanguard on the definitions of ‘beta’ and ‘index’, I am unlikely to be confused for a ‘Boglehead’. However, I have the highest respect for Jack Bogle’s contributions. In fact, I would love to see the smart beta revolution yield the next wave of low cost investment solutions firmly grounded in academic research and the investor-centric philosophy he championed. However, we’re a long ways off from there at the moment and I’m concerned. Let me explain.

The natural conflicts between asset owners and asset managers

It is no secret that investment management firms are profit-seeking organisations relentlessly competing for more assets. Even small investors who are unsure of the difference between active and passive managers know that both are trying to make a living. So, for the record, let’s say it loud and clear: investment management is a for-profit enterprise. As such, asset managers and asset owners have a relationship beset with natural conflicts.

Asset owners want fees below 10 basis points (0.10%); asset managers prefer ‘2% + 20%’ (a flat fee of 2% on assets under management plus an additional 20% of outperformance). Asset owners want transparency; asset managers favour black-box opacity. Asset owners want simplicity; asset managers hire rocket scientists to create complex optimized solutions for sex appeal. (‘Optimised backtests’ sell better irrespective of their actual relationship to future performance.) Asset owners want ‘future’ outperformance after they fund a manager; asset managers would be satisfied with strong past outperformance to facilitate future asset gathering. Asset owners want a bigger alpha; asset managers would happily sell them the possibility of alpha and charge handsomely for the service of selling hope.

Where does ‘smart beta’ come in?

So, how does all of this relate to smart beta? Currently, asset managers are arguing heatedly about the right definition for smart beta. Some of our fellow investment managers secretly, and some publicly, hate the smart beta moniker. It’s not the ‘smart’ that annoys them. We all think we are plenty smarter than the market. We simply wish it were called ‘smart alpha’. If normal alpha could fetch ‘two and twenty’, imagine what one could charge for smart alpha!

In fact, the debate about the right definition for smart beta reminds me of a parallel debate in risk parity. The absurdity of the fixation around definition is best captured by the following comment made by a senior investment consultant: “The conversation in the risk parity space is pure nonsense. Every quant manager argues that they have the most correct method for achieving risk parity in a portfolio. No one seems to address how achieving equal risk contribution for securities in an investment product is actually good for the end investor or why it is even relevant.” Isn’t it time to stop debating the definition of smart beta and focus on the most important question, “What’s in it for the end investor when it comes to smart beta?”

The same core yet simple insight that motivated Jack Bogle to launch a capitalisation-weighted index fund has the potential to be a transformational insight for smart beta as well - and that’s simply knowing the right question and having the courage to answer it. Given all we know about modern finance, what is best for investors?

When I think about the original index fund, the promise to investors was clear: a transparent, low-cost, low-governance, high-capacity strategy for accessing the equity risk premium through cap-weighted exposure to market beta. For investors who are under pressure to reduce expenses, who have limited resources for selecting and monitoring active managers, who have extremely large assets, or who have lost faith in active management, the first index mutual fund and its many offshoots delivered on that promise. They provided a portfolio that, over the long horizon, outperformed the average active manager (especially on a net-of-fees basis) while requiring almost no attention. No stock stories, no brilliant but idiosyncratic portfolio managers—and no need for the beauty parade that we call manager selection. Emotionally, index investing deprived clients only of the illusion of control, and in exchange for that trivial sacrifice it entertained them with the daily ups and downs of the market as a whole.

Finance theory and knowledge have advanced tremendously since Vanguard launched the first index mutual fund in 1976. We now know that there is more than just the market factor which generates an equity return premium over time. Eugene Fama won the Nobel Prize in Economics, in part, for demonstrating that there are three reliable sources of equity return. Today the Fama–French three-factor model, or some variant of it, is used by nearly every quantitative analyst to examine equity returns. Robert Shiller won his Nobel Prize in Economics for arguing that investors’ enduring behavioral biases can generate persistent anomalies in the financial market that can be exploited for outperformance. The literature today is populated by evidence that value, momentum, and the low beta anomaly are rooted in investors’ behavior.

Frontier knowledge has changed

Exactly 40 years later, what would a challenge to our industry like Paul Samuelson’s mean? The frontier academic knowledge has changed—there are multiple ‘betas’, not just the market beta, which provide persistent premia over time. But some things have remained the same. Costs always erode investors’ returns and skilled stock picking is unnecessary for successfully investing in these alternative equity betas.

I wish for smart beta to be 2014’s answer to Samuelson’s challenge just as Vanguard’s first index mutual fund was the answer in 1974. We know how to design simple, low-turnover, and well-diversified core-like portfolios which access the premia associated with the various known equity return factors. Through the index chassis, which requires systematic and rules-based portfolio construction and thus promotes transparency, we can lower governance cost and reduce investment management expenses. When designed properly, smart beta strategies can be the prime alternative to active management for our times just as cap-weighted index funds served so admirably in that role for the past four decades.

I would be saddened if the allure of gathering assets causes providers to allow smart beta to deteriorate into the deception of ‘backtest alpha’. I hope for a far better outcome. I hope smart beta shakes up the business-as-usual world of investment management. I hope smart beta funds pull assets away from closet indexers and the high-load, high-fee active products which survive, through effective advertising, at the expense of investors. Finally, I hope this disruptive new entrant goes on to transport index investing from the one-factor thinking of old to the multi-factor framework of modern finance. That is the promise of smart beta for me as an investor and an academician. As an asset manager, I aspire to deliver on the promise of smart beta just as the pioneers of indexing did 40 years ago for the cap-weighted market beta.

 

Jason Hsu is Co-Founder and Vice Chairman of Research Affiliates LLC. This article is general information and does not consider the personal financial circumstances of any investor, and readers should seek their own professional advice.

RELATED ARTICLES

10 reasons many fund managers are now blank spaces

Great investment expectations are deluded

Smart beta: watch the details

banner

Most viewed in recent weeks

10 reasons wealthy homeowners shouldn't receive welfare

The RBA Governor says rising house prices are due to "the design of our taxation and social security systems". The OECD says "the prolonged boom in house prices has inflated the wealth of many pensioners without impacting their pension eligibility." What's your view?

House prices surge but falls are common and coming

We tend to forget that house prices often fall. Direct lending controls are more effective than rate rises because macroprudential limits affect the volume of money for housing leaving business rates untouched.

Survey responses on pension eligibility for wealthy homeowners

The survey drew a fantastic 2,000 responses with over 1,000 comments and polar opposite views on what is good policy. Do most people believe the home should be in the age pension asset test, and what do they say?

100 Aussies: five charts on who earns, pays and owns

Any policy decision needs to recognise who is affected by a change. It pays to check the data on who pays taxes, who owns assets and who earns the income to ensure an equitable and efficient outcome.

Three good comments from the pension asset test article

With articles on the pensions assets test read about 40,000 times, 3,500 survey responses and thousands of comments, there was a lot of great reader participation. A few comments added extra insights.

The sorry saga of housing affordability and ownership

It is hard to think of any area of widespread public concern where the same policies have been pursued for so long, in the face of such incontrovertible evidence that they have failed to achieve their objectives.

Latest Updates

Strategy

$1 billion and counting: how consultants maximise fees

Despite cutbacks in public service staff, we are spending over a billion dollars a year with five consulting firms. There is little public scrutiny on the value for money. How do consultants decide what to charge?

Investment strategies

Two strong themes and companies that will benefit

There are reasons to believe inflation will stay under control, and although we may see a slowing in the global economy, two companies should benefit from the themes of 'Stable Compounders' and 'Structural Winners'.

Financial planning

Reducing the $5,300 upfront cost of financial advice

Many financial advisers have left the industry because it costs more to produce advice than is charged as an up-front fee. Advisers are valued by those who use them while the unadvised don’t see the need to pay.

Strategy

Many people misunderstand what life expectancy means

Life expectancy numbers are often interpreted as the likely maximum age of a person but that is incorrect. Here are three reasons why the odds are in favor of people outliving life expectancy estimates.

Investment strategies

Slowing global trade not the threat investors fear

Investors ask whether global supply chains were stretched too far and too complex, and following COVID, is globalisation dead? New research suggests the impact on investment returns will not be as great as feared.

Investment strategies

Wealth doesn’t equal wisdom for 'sophisticated' investors

'Sophisticated' investors can be offered securities without the usual disclosure requirements given to everyday investors, but far more people now qualify than was ever intended. Many are far from sophisticated.

Investment strategies

Is the golden era for active fund managers ending?

Most active fund managers are the beneficiaries of a confluence of favourable events. As future strong returns look challenging, passive is rising and new investors do their own thing, a golden age may be closing.

Sponsors

Alliances

© 2021 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. Any general advice or ‘regulated financial advice’ under New Zealand law has been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. For more information refer to our Financial Services Guide (AU) and Financial Advice Provider Disclosure Statement (NZ). You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.

Website Development by Master Publisher.