a report card for smart beta

Purveyors of “smart beta” equity portfolio strategies have been very popular over the past few years, both with individual investors and with institutions.

The source of the attraction is clear:

smart beta claim to provide better performance than an index fund without engaging in active portfolio management. Actually, it claims to outperform because it doesn’t employ value-subtracting human portfolio managers to muck up the works.  Rather, smart beta operates by reshaping the weightings of stocks in the index according to predetermined computer-managed rules.  (I’ve written about smart beta in more detail in other posts.)

In other words, it’s free lunch.

My observation is that smart beta is a marketing gimmick  …one that has been very successful in bringing in new money, but a gimmick nonetheless.  Basically what it does is to create a portfolio that contains the index constituents, but in different proportions from their index weightings.  The rules for determining the smart beta weightings are set in advance and the portfolio is periodically rebalanced to restore the “correct” proportions.  For my money, the preceding sentence describes active management.  The portfolio managers are just hidden behind a computer curtain.

A simple example of smart beta:  maintain a portfolio of S&P 500 names but have .2% of the money in each stock–rather than having it loaded up with lots of Apple, ExxonMobil, Microsoft, Johnson&Johnson and Berkshire Hathaway.  Historically, this is a strategy that had its best run in the late 1970s – early 1980s, but which followed with a very extended period of sub-par performance.


I was catching up on my reading of the Financial Times over the weekend and came across an article from the FTfm of February 2nd titled,“Smart beta is no guarantee you will beat the market.”

It turns out that of the 10 biggest smart beta ETFs in the US, seven have underperformed over the past three years and five over the past five years.

That’s not that different from what active managers have done.

However, unlike the case for active managers, assets under smart beta management have grown fivefold since 2009.




the FT, Vanguard and Morningstar: active vs. passive investing

Saturday’s edition of the Financial Times opens with a screaming front-page headline, ” $3.5 billion pulled out of Fidelity funds.”  

 …must have been a slow news day.  

The article goes on to explain that net inflows of individual investor cash into the stock market–both in the EU and the US–over the first half of 2014 have been going to index products, not to active managers. 

I can see several good reasons why this is so:

1.  Indexing is like cruise control.  You know you’re going to get more or less the return on the index against which a given index fund/ETF is benchmarked.  So you only have two variables to consider:  how closely the fund/ETF is able to track the benchmark, and what its expense ratio is.  There’s no fretting about an active manager’s style and strategy, or whether he/she is still running the portfolio whose historical record you’re examining

2. Fidelity doesn’t necessarily want mutual fund customers.  I’ve had a Fidelity brokerage account for decades.  Fidelity has never approached me, ever, to buy a mutual fund product of any type.  I presume it’s because the company makes more money from having me trade individual stocks.

3.  Picking active managers takes some effort.  It requires having some understanding of the stock market and an ability to deduce strategy from the lists of holdings that managers report each quarter to the SEC.  

True, there is Morningstar, a service which has been providing its famous “star” rankings of mutual funds for about a quarter century.  Although Morningstar, disingenuously, warns buyers of its star information not to use it as the reason for picking a given mutual fund, people do pay for the rankings.  So they must have a reason.  Investment management companies take out full-page adds to tout their high star-ness.  Inflows seek high-star funds and shun low-star ones.

Over at least the past several years, however, Vanguard points out that following Morningstar rankings hasn’t been a good idea.  The index fund giant is publicizing a study it did of Morningstar fund rankings from 2011 – 2013.  Over the three years, Vanguard says there was a strong correlation between Morningstar star ranking and fund performance, but it was the opposite of what the rankings suggested.  One-star funds performed the best vs. their peers, two-star funds the next best   …and so on, in order, with five-star funds performing the worst.  Whoops!

Personally, I’ve never been a fan of Morningstar’s use of short-term volatility as a measure of the riskiness of a portfolio.  My guess is that the relative stability of a fund’s NAV ends up being the most important factor in getting a high star rating.  So that rating has little to do with future return potential.  But I have no real idea how Morningstar could have gone as badly astray as Vanguard says.

Anyway, to sum up, if there’s any news in the FT article, it’s the (understandable) extent to which individual investors are embracing psssive investing, not the fact that they’re doing so.




types of stock indexes

Indexes can be categorized in several different ways, including:

reach, or coverage


There are broad market indexes like the S&P 500, which cover all the important sectors and contain all the key large-capitalization stocks within a geographical region.  In this case it’s the US.  There are similar indexes for all the other major–and most minor–stock markets of the world.

There are also indexes that cover larger geographical regions, like North America, the Americas, Europe, the EU, Greater China, Asia, the Pacific…

There are also indexes like EAFE (Europe, Australasia and the Far East), which covers the world ex the US and Canada.  It’s purpose is to provide a benchmark for foreign stock portfolios held by US or Canadian investors.  There are similar indexes for the World ex Japan, World ex UK…


There are also indexes that focus on specific sectors or industries, sometimes divided into local and foreign, depending on the portfolio being measured.


There are also indexes that focus only on mid-cap or small-cap stocks, like the S&P 400 (mid-cap) or S&P 600 (small-cap).  With these, the definition of what counts as mid-cap and what’s small-cap may vary from index provider to provider.

investing style

Personally, I find these more problematic, but there are also indexes that claim to contain only value stocks and others that contain only growth stocks.  The sectoral composition of such indexes can deviate wildly from each other, as well as from a larger, style-neutral index.

how the index is calculated

Virtually all today’s stock market indexes are capitalization-weighted.  That is, the effect of the price change of any given stock in the index is based on the total market value of all that company’s outstanding shares.  Stocks where this value is large have more influence on the index movement than whose where the value is small.


Let’s say the index contains three stocks, whose value totals 100.

Stock A has a market value of 70

Stock B has a market value of 20

Stock C has a market value of 10

On a given day, A rises by 1%, B by 2%, C by 3%.

The change in the index is calculated as follows:

(.7 x .01) + (.2 x .02)  + (.1 x .03)  =  .007 +.004 + .003  =  .014

The index rises by 1.4% that day.  The greatest influence on the index performance is stock A because it’s much larger than the other two.

A variation on capitalization weighting is free float weighting.  It may be that in a given country, the government or a powerful family owns a large chunk of one or more large-cap stocks.  The part that’s so held is never traded.  It’s said not to be part of the pubic “float.”  Where this is the case, indexes often weight the stock using only the float, not the full market capitalization.


equal weighting

The Value Line index is an example.  In an equal weighted index, all constituent stocks count the same.  In the example above, an equal-weighted index would be up by 2%.

Versus a capitalization-weighted index, an equal weighted one gives much greater emphasis to smaller stocks.

the Dow and Nikkei Dow

These indexes are wacky.  They use the per share stock price as a weighting factor.  In other words, a $100 stock counts for 10x what a $10 stock does, no matter what the total size of either company is.  To my mind, this is sort of like saying a nickel is worth more than a dime because the coin is larger.

“fundamental” weighting

At one time in the recent past, some investment managers claimed they were offering an index product in which stocks were selected as index constituents either because they had a strong record of high and increasing dividend payments, or because they combined strong earnings growth with modest stock market valuations.

To my mind, this is a marketing ploy.  These are active management offerings, not index funds/ETFs.  The active manager has decided to rely exclusively on mechanical rules that embody his investment judgment.  Many value managers do much the same thing.

As far as I can see, the investment managers I’ve heard making index claims for their products have stopped doing so–with or without the prompting of regulators I don’t know.

stock indexes and indexing

what stock indexes do

Stock indexes have two main functions:

1.  They provide information about how stocks in general are doing.  Part of this is that it’s nice to know, sort of like the weather. But that’s not all.  The broad stock market has an important role in macroeconomic forecasting.  In the US, the stock market is historically the most reliable leading indicator of economic activity.  Even in today’s world where half the market’s profits come from abroad, changes in stock market direction tend to accurately foretell changes in economic growth that occur around six months later.

2.  Indexes serve as measuring tools to assess the performance of professional money managers.  Three factors have made the role of benchmark increasingly important:

–the widespread rise, post-WWII, of pension plans for workers,

–The Employee Retirement Income Security Act (ERISA).  This Federal legislation, passed in 1974, set down strict standards for corporate stewardship of employee pension plans, and

–rising affluence, which has transformed stock market investing from the exclusive province of coupon-clipping bluebloods into an arena where middle-class Americans can, and do, participate.

academic research on active management

Most of the finance taught in universities is pure nonsense, in my view.  The real world is much more complex than professors realize.  Nevertheless, academics do do good empirical research studies.  One of their most devastating findings is that the typical professional, or “active” investment manager in the US routinely underperforms his benchmark index.  Almost no one outperforms after deducting the fees he charges for his services.   Ouch!  (As it turns out, my portfolios generally outperformed, but I usually ran portfolios that had large exposure to foreign markets–which are another story).

Once ERISA forced pension funds to pay attention, they quickly learned this lesson.

Hence the rise of index funds, which track very closely the performance of benchmark indexes like the S&P 500 and have extremely low costs.  That’s “low” in the sense of better performance than an active manager, at far less than 10% of the costs.

lots of index providers

Standard and Poors has a whole slew.  So does the Financial Times.  Pension consultant Frank Russell has a bunch, too.  And MSCI.

Why so many?  

–They’re profitable.  They’re also relatively easy to set up.  All you need is the money to hire a few quants and a giant computer.

–The first guy in collects the most assets.  Therefore, unless he really messes up, he should have the lowest costs.  And as a result of that, he should get the majority of new inflows.  So it’s much, much better to have an index fund product a little in advance of any demand.  Being late to the party is devastating.

they’re all a little bit different

The FT index for large-cap US stocks has somewhat different constituents from S&P’s;  both are different from Russell’s.  That’s to make it more expensive for large institutional clients, who may pay only a few basis points per year in fees, to switch among index fund providers.  So they can’t play one provider off against the others and bargain for lower fees.

More tomorrow.