“smart beta” (ll): traditional active management in a “passive” package

how active manager operate

Active managers create portfolios that differ from a benchmark index, such as the S&P 500.  The do so in an effort to achieve higher returns than the index.  History shows that very few manages with public records succeed.  They follow one or both fo two basic strategies:

–they hold stocks that are not in the index, as substitutes for index constituents, and/or

–they hold index constituents in different proportions than the index–having more or less depending on their assessment of valuation and future prospects, as well as the strength of their conviction.

Conceptually, it’s as simple as that.

smart beta

Purveyors of “smart beta” say they’re not active managers.  What they do instead of seeking (dumb) alpha is to change the index being used by the client–not through subjective judgment but by using flat-out rules, enforced not by a fallible human but by a computer program!

The simplest smart beta “product” is to use an equal-weighted index rather than a capitalization-weighted index like the S&P 500.  The difference?  Let’s say we’re using the members of the S&P 500 as our universe of names.  Capitalization weighting means percentage changes in the value of stocks with gigantic market values, like AAPL, XON or MSFT, count for more than tiny ones.  Equal weighting means each stock counts the same–.2% of the index total.

The result is a substantial shift in emphasis away from large-cap stocks and toward small ones.  The decision to do so is clearly a subjective judgment made by a human being.  By calling it “beta,” however, it is being packaged as a passive/index judgment that supposedly  doesn’t introduce more risk into the portfolio.

More ambitious smart beta products include collecting analyst earnings estimates, calculating forward PE ratios and creating a portfolio that’s tilted more or less strongly toward the lowest PE, highest earnings growth members of the investment universe.  Subjective rules about what combination of factors should be favored/disfavored are crystallized into a computer program that performs the requisite rebalancing of the portfolio as new information emerges.

This is straight out of The Wizard of Oz.  Don’t look behind the curtain!

There’s nothing passive about this approach except the name.  Having worked at Value Line, which used a more sophisticated version of this approach fifty years ago, I recognize what’s going on very clearly.  Only Value Line was more upfront about what it was doing.

Smart beta is almost exactly what many traditional active value managers do in practice.  They’re extremely rules bound, although, unlike smart beta, they reserve the right to override the rules in unusual circumstances.

why is this approach appealing?

Several reasons:

–pension plan sponsors whose plans are seriously underfunded–and that’s those of most government bodies–are in a very difficult position.  They need either to up the returns they are achieving on their assets, or ask their bosses to increase contributions to the plans.  The latter is probably the first step on the (short) road to unemployment.  So these sponsors are very open to any approach that promises high returns without extra risk.  Look at the explosion of investment into hedge funds, despite these vehicles’ sub-par performance records.

–the idea that an “objective” computer is running the show rather than a fallible group of individuals has, for some reason, a lot of appeal

–smart beta products up the risk of an overall portfolio.  But it’s not 100% obvious that they’re doing so.  So there’s some chance of explaining away underperformance if it occurs

–in addition to being less obvious as active management, they may be cheaper than hiring a new active manager.

To my mind, this will all end in tears, both for the purveyors of these products and the buyers.  The Value Line experience is a case in point.




2 responses

  1. There’s an interesting article in this week’s Economist (actually two articles) regarding the money management industry (Cheap is Cheerful and Will invest for Food). The articles cite “smart beta” as one of three reasons for the current pressure on the money management industry (the other two reasons cited are the rise of low-cost ETFs and the increase in defined contribution retirement plans). You think there is a chance that this may be a signal that these trends may have peaked?

    • I think the fee pressure on traditional money managers is going to continue, at least in the retail sphere. Three factors: active managers still charge high fees, but generally underperform; financial planners of all stripes are asset allocators, so it’s in their interest to emphasize these services as the valuable ones; and most active managers still charge a percentage of assets for their services. I think there’ll be continuing long-term pressure to change that to a flat fee, both because clients have more market power and the commonsensical idea that a manager shouldn’t get paid 30% more just because the market has gone up.

      As to Smart beta, if it’s like other fads I’ve seen, it won’t lose popularity until it’s clear it doesn’t work–a long period of large-cap outperformance, or a down market in which portfolios are punished for taking on more risk.

      ETFs showed in early 2009 how potentially illiquid they can be. During the market bottoming process, some ETFs sold at 90% or less of NAV in market trading. No one seemed to care–maybe because they had bigger fish to fry. Dependence on third-party market makers is the one problematic factor with ETFs that I see, so I think they’re here to stay.

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