(This guest blog arose out of comments posted by Mr. Surz to a previous ThinkAdvisor article on smart beta, How Advisors Can Understand, and Use, Smart Beta Strategies. We invited Mr. Surz to elaborate on his comments in this guest blog.)
Fundamentally weighted indexes were introduced by Robert Arnott in 2004, and have come to be known as smart beta indexes because they are professed to outperform the market, as represented by traditional capitalization-weighted indexes. Hundreds of billions of dollars have flowed into smart betas, but some of that money would be better placed in new, improved smarter beta indexes. Smarter beta indexes can beat the market too, plus smarter betas complete active managers, rounding out investment portfolios. Smarter betas are targeted for active-passive investors rather than all passive. You need to determine how smart your beta should be.
Fundamental (smart beta) weights typically tilt toward value and smaller companies relative to their cap-weighted counterpart, because this tilt has a history of performing better, so it may be smart. The future will tell us how smart this actually is. Fundamental indexes are created for broad markets, like the U.S. or Europe; they are total market indexes.
Even Smarter Betas
Because smart beta indexes encompass entire markets, they are not intended to be used in conjunction with active managers. If smart beta indexes are combined with active managers they dilute active manager decisions by adding stocks active managers don’t want to hold. Furthermore, they tilt the entire portfolio toward smaller company value, potentially undermining portfolio structure, especially growth allocations. Smart beta indexes play a specific role that does not involve active managers.
By contrast, smarter beta indexes complement active managers by serving as a smarter core in core-satellite portfolio constructs; it’s even smarter than smart beta in this situation.