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.

Anyway,

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.

 

 

 

“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.

 

 

 

what is “smart beta”? (l): alpha and beta

I’m going to write about this in two posts.

Today’s will give some basic background. Tomorrow’s will look at smart beta itself.

alpha and beta

Right after WW II many professional investors, and academics as well, were eager to apply newly emerging computer technology to analyzing the stock market.  Harry Moskowitz, an IBM scientist, was the first.  He suggested using computers to record and analyze the interrelations in price action among all the stocks in the market.  But measuring the reciprocal influences on even relatively small numbers of stocks proved too daunting for the computing machines of the day.

That led to the idea that the task be simplified by not relating each stock in a universe like the S&P 500 to each of the other 499.  Study, instead, how they each behave in relation to some common standard–in fact, relate each to the index itself.  un a regression analysis that correlates the daily price change in each stock with the price change in the index.

An equation showing the results for a stock “y” would be in the form:

y = α + βx + an error term that can be ignored

So the price change “y” for any stock can be broken down into two elements:

systematic,return, or beta, the portion due to market fluctuations.  For academics, this is a constant “β” derived from the regression, multiplied by “x,” the price change in the market  and,

a non-systematic term or alpha,, an “extra” return, that can be either positive or negative.

By definition, the β of the market = 1.0 (the sum of all the returns of the market components = the return on the market).

In the strange world of academic financial orthodoxy, it’s impossible to achieve a positive α. The only was investors can achieve a higher return than the market is by arbitrage–by borrowing money and buying what amounts to an index fund.

The popularity of this view–whose only virtue as I see it is its simplicity–shows itself in industry jargon.  Active managers are said to be “seeking alpha.”  Pension plan sponsors routinely separate their equity assets into active and passive, the latter being moneh invested in “safe” index products.

“Smart beta” is a marketing approach by active managers to e a portion of their “safe” index assets to the “seeking alpha” pool.  Apparently they’re successful, although the essence of their pitch is semantic—-they label their active managing activity as being “beta,” not alpha.  It’s the equivalent of the old junk bond pitch, “all the safety of bonds, all the high returns of stocks.”  We all know how that ended.

More tomorrow.