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Weekend reading: Is smart beta a dumb idea?

Good reads from around the Web.

The debate about ‘smart beta’ – the passive strategies that seek to give index investors some ‘alpha’ edge – has found its way into the Financial Times [1]. [Search Result]

For those confused about the terms, FT journalist John Authers explains:

A stock with a beta of 1 moves exactly in line with the market at all times. The market itself has a beta of one.

Alpha is the variable that captures all market moves that cannot be explained by the market.

In financial parlance, you can buy beta very cheaply by buying an index fund. Meanwhile alpha is elusive and comes at a price.

This justifies the rise of passive index funds and exchange traded funds. They give you beta, cheaply.

But index funds are dumb, accepting prevailing valuations unthinkingly.

So why not offer index-like fund management that works automatically, and so keeps costs down, while exploiting anomalies in stock valuations to try to beat the index?

It sounds great in theory, and here on Monevator [2] we’ve already looked at ways you might try to benefit – by investing in the value premium [3] for example.

However we’re suspicious of claims that these strategies are a no-brainer route to extra returns for all. We suspect at the least you’ll pay in terms of higher risk, volatility, and trading fees.

I think there’s also a danger that the market will arbitrage away your smart beta strategy before it has actually delivered its excess gains into your portfolio.

Worse, you won’t know whether that’s what’s happening – or whether your strategy is just having an off-year or five – until it’s much too late.

Sick idea

Stamford University’s Bill Sharpe – who won a Nobel Prize for inventing the concept of beta – has a more visceral reaction.

Apparently the concept of smart beta makes Sharpe “definitionally sick”!

Sharpe says all such strategies are factor bets like the value one I just mentioned. He doubts they will last if widely followed.

In response, some smart beta advocates say their strategies will keep outperforming because the benefits come through rebalancing.

(A similar discussion flared up in last week’s comments [4] on Monevator.)

Wouldn’t it be nice to live in their world?

I don’t know whether or not smart beta is a fad. I’m just a humble would-be George Soros [5] in my spare bedroom, bereft of Nobel recognition.

But I do doubt you can get something for nothing. So if smart beta survives, I think it will come with downsides.

For his part, Bill Sharpe seems dismayed by how easily smart beta has captured the imagination:

“I used to worry: what if there’s too much indexing? But human nature means people keep on backing active managers.”

Yet who can blame them, when in theory it seems so easy to do better?

Look at this graph from Millennial Invest [6]. It shows how a US large cap index fund would have done if you removed the bottom 10% of stocks per various smart beta style factors, such as worst value, worst momentum and so on:

Graph showing how an index of large cap stocks without the worst decile of poor choice companies outperforms,

A theoretical large cap ‘smart beta’ outperforms handily

Its creator, Patrick O’Shaughnessy, says that:

Diversification is good…to a point. But owning everything—even the junk—can be a drag on returns over the long term.

And he’s right, of course.

Similarly, while active investing is usually seen as a process of finding the winning stocks, we might as easily see it as a process of trying to eliminate the thousands of duds.

Factor in the risk of failure

Most active investors fail in their quest, and maybe most smart beta investors will meet the same fate.

For starters, as best I can tell the theoretical returns in the graph above ignore costs.

Then there’s human emotion to consider…

Any non-pure index strategy will sometimes do worse than the index: That’s a guarantee you can take to the bank. So anyone who bets on smart beta will have to endure periods of bad performance – not in hindsight on a graph, but in real-time over years and maybe decades, as their strategy lags the market and their time horizon dwindles.

They will have to faithfully hold on to make up for these poor years, with no certainty they’ll be rewarded. Many will capitulate at the worst time.

Is that a smart strategy?

For a small percentage of your money in the hope of just a glimpse at the Holy Grail, perhaps it’s worth a gamble.

But I wouldn’t bet the house on it.

On an unrelated note: Come on England [7]!

From the blogs

Making good use of the things that we find…

Passive investing

Active investing

Other articles

Product of the week: Want a new smartphone? uSwitch research cited in The Telegraph [24] found that waiting just nine months before buying a new edition handset can reduce your costs by 24%.

Mainstream media money

Some links are Google search results – in PC/desktop view these enable you to click through to read the piece without being a paid subscriber of that site.1 [25]

Passive investing

Active investing

Other stuff worth reading

Book of the week: I’ve bought my copy of Timothy Geitner’s Stress Test [38]. Perfect summer reading for those of us still fascinated by the crash.

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  1. Reader Ken notes that: “FT articles can only be accessed through the search results if you’re using PC/desktop view (from mobile/tablet view they bring up the firewall/subscription page). To circumvent, switch your mobile browser to use the desktop view. On Chrome for Android: press the menu button followed by “Request Desktop Site”.” [ [41]]