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Rob Arnott and the Rise of Smart Beta

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Investment advisors invest their clients’ money based on a range of philosophies and client needs. Advisors are often skeptical of following massive flows of money, preferring to stick to a planned asset allocation and fund families with which they’re comfortable. Think of all the money that flowed into bonds during 2012 as the equities’ bull run gathered steam. Investors were climbing that wall of worry, but advisors’ job is to manage emotions in investing.

So what to make of the massive flows of money that have been going into vehicles—mutual funds and especially ETFs—that pay homage to “smart beta”? Are those fund flows merely a response to smart marketing ploys? Does the entire notion of smart beta make any sense? Is it not just taking a tilt toward active investing nestled in an index wrapper?

When asked these questions, the father of fundamental indexing, Rob Arnott of Research Affiliates, asked some of his own. “Do you want to have a core portfolio that looks like the stock market?” he asked in a December interview, or one that “looks like the actual economy?” For him, fundamental indexing is a “core equity strategy … meant to emulate the actual macroeconomic footprint” rather than a capitalization-weighted strategy that “tries to emulate the stock market.”

For those who argue that fundamental indexing is only a “clever repackaging of value strategy,” Arnott argued that “conventional value investing is still capitalization-weighted,” so overvalued value stocks “will have too much weight” in a portfolio while undervalued value stocks will have too little.

Fundamental indexing—building an index based on the fundamentals of a given stock, instead of its market price—is just one of the strategies that go into smart-beta investing vehicles, along with equal weight and low volatility indexing, among others. While Arnott said that Research Affiliates is mistakenly credited with inventing the term “smart beta,” he does think it’s “fun,” and he feels a certain “avuncular pride” in the term.

Arnott said you can use fundamental indexing as an “active value alternative.” Despite what he calls some early ad hominem attacks over fundamental indexing, he seems to relish some of the arguments over whether smart beta is ill-defined or illegitimate. “I find the debate fun; Jack Bogle says it’s more expensive than cap weighting with more turnover, but it’s way less expensive than active management.” 

But what about the money going into smart beta: How much is there, and who’s putting it there? What exactly is smart beta, and what is the experience of advisors who have adopted the strategy, at least in part, in building client portfolios? Does it actually work as advertised?

Following the Money Into Smart Beta

In an interview, Tony Davidow, vice president at Schwab’s Center for Financial Research, where he focuses on alternative beta, cited BlackRock research that found that the total dollars in smart beta reached $180 billion as of November 2013, with $45 billion attracted to those strategies in 2013 alone. Of that amount, he said there was “roughly $156 billion in assets following RAFI strategies,” referring to Arnott’s Research Affiliates Fundamental Indexes.

Bloomberg reported in February that smart-beta products had brought in a total of $43 billion in 2013, bringing total assets to $156 billion as of the end of February 2014.

A Cogent Research study released in January found that 25% of institutional investors surveyed are already using smart-beta ETFs, and that 46% of those institutions, especially those with more than $500 million in assets, who are not currently using smart-beta ETFs plan to do so over the next three years.

Recent data from international consulting firm Towers Watson confirms the popularity of smart-beta strategies among its institutional clients. During 2013, those institutions made over twice as many new investments in smart-beta strategies, it reported in early March, totaling $11 billion across over 180 portfolios, compared to the year before (approximately $5 billion across almost 130 portfolios). Over all, Towers Watson says its institutional clients globally have now allocated over $32 billion to smart-beta strategies in almost 500 portfolios, across a range of asset classes.

Defining Smart Beta

Rolf Agather, managing director of research and innovation for Russell Investments, presented a paper to the CFA Society of Miami in October 2013 that provided some clear guidance on smart beta.

First, a definition. “Smart beta,” he said, is first of all a plural, not a singular strategy, that includes “transparent, rules-based investment strategies that are designed to provide exposure to market segments, factors or concepts.” These strategies sit at “the intersection of active and passive management” for investors who are looking for a “complement to traditional passive strategies.”

Towers Watson defines smart beta this way: “To believe in the smart-beta proposition, one must first accept that there is a wider framework than the narrow definitions of alpha and beta that classic finance theory puts forward. In this framework, somewhere between alpha and beta, lies smart beta.”

Davidow of Schwab argued that the fundamental index-based strategies of RAFI have not only strong academic research but “now a track record” of performance, which has driven demand for those strategies, particularly among institutional investors.

“Not all alternatives are created equal,” Davidow said. He acknowledged that while there are many smart-beta strategies available to advisors, they yield “very different results over time.” Moreover, Davidow said that in looking at passive strategies, “both market cap and fundamental strategies are complementary.”

For example, under some market conditions, market-cap weighted strategies will perform better in what is known as the “Apple effect.” “If you’re overweighting the biggest companies in the index, sometimes you’re rewarded, like Apple in the first three quarters of 2012.” However, over the last quarter of 2012 and the first of 2013, when Apple’s share price declined, so too did the underlying S&P and the market-cap weighted mutual funds and ETFs based on that index. “Much of the return differential is explained by the Apple effect,” Davidow said.

In an interview at the Schwab Impact conference last year, Marie Chandoha, president and CEO of Charles Schwab Investment Management, said that smart beta is “alternative indexing” that provides a “much smoother ride” than traditional indexing and provides close to 200 basis points over the returns provided by traditional indexing. According to Research Affiliates’ own research, that 200-bps overperformance is within developed markets, with the potential for more outperformance in less efficient emerging markets, said Arnott. The “alpha” in this beta strategy, along with the inherent cost savings in an index-based strategy, provides plenty of value to end investors. It’s that extra performance, and the promise of lower volatility, that has attracted earlier-adopting institutional investors, including some advisors. All advisors and end investors would also be pleased by the transparency of the strategy, since smart beta is based on published rules-based indexes.

There’s another benefit in using both passive and active approaches: keeping clients invested in the market. “There are some advisors who can and will make tactical calls” as market conditions change, but Davidow said “most advisors want to keep their clients engaged.” Using smart beta can reduce a portfolio’s volatility over time, so it’s more likely clients will “stay committed to the plan,” he said.

That’s why “there’s a role for market-cap and fundamental” index investing and for advisors to identify “those strong active managers who can play defense in troubled market times. If you believe there will be shocks to the market, wouldn’t you want a manager who can play defense?”

So what’s the value of smart-beta strategies, and are advisors interested in those strategies? “There’s so much interest in this because it shows excess return,” said Davidow. While the approach “stacks up well from an alpha perspective relative to market cap and active managers,” he said, it’s not just “excellent returns, but also risk-adjusted returns” that smart beta can provide. Furthermore, if they’re “delivered in an ETF or mutual fund, they tend to be cost effective.”

Two Advisors’ Experience Adopting Smart Beta

It’s those benefits—risk-adjusted returns delivered through transparent strategies—that have led two advisors to use smart beta in client portfolios. At the RIA firm Gemmer Asset Management, which manages money for its own clients and some $80 million for other advisors, Charles Blankley, principal and chief investment officer, said smart beta is a “core piece of our portfolios.”

Beginning in 2007 and attracted by fundamental indexing’s promise to “break the link between cap weight and price,” Blankley said he particularly likes the strategy in the small-cap space, which provides good risk-adjusted returns “without giving up much on the upside.” End clients “don’t demand it,” said Blankley, so some education is necessary, but once educated, they embrace the philosophy and are pleased with the returns. Using commission-free ETFs on the Schwab platform provides two other benefits, Blankley reported, since “in a world with 5% to 6% returns, cutting out fees makes a big difference,” and those trade-commission-free ETFs “allow us to rebalance with zero commissions.”

Jonathan Citrin, founder and executive chairman of RIA firm Citrin Group, said his firm “rebooted to a smart-beta approach,” partly because “we never cared about benchmarking because we never believed a market-cap index reflected the stock market.”

He said modern portfolio theory “led us to Rob [Arnott] and fundamental indexing.” First, “we gave it some time before adopting,” poring over research from Research Affiliates, but since then “we’ve been very pleased.” However, Citrin does exhibit the traditional RIA’s skepticism on investing vehicle marketing; while “we’re a big fan of the concept of smart beta, we’re not of how it’s sold.”

For Citrin, smart beta fits in with his firm’s goal of “taking the emotion out of the investment process.” He said that “my big problem with market cap all along is that it’s made up in the short term of human emotion” since it’s based on a given stock’s price, which is determined by human emotions about the stock. “Smart beta,” he said, “fits much better into an unemotional approach.”

Some advisors were early adopters of smart beta, according to Schwab’s Chandoha, but institutions were there before them due to their “big rotation to index strategies” as they searched for more predictability. The strategies’ acceptance has grown since the financial crisis, said Chandoha, as investors looked for more downside protection to “mitigate those tails.” That’s not to say that cap weighting doesn’t have a role to play, Chandoha was quick to say. “If you’re concerned more with the short term, complement your investing approach with cap weighting,” she suggested, but “longer term, go more fundamental.”

Arnott pointed out that adoption of fundamental indexing smart-beta strategies is also a “global phenomenon,” with large fund flows to the strategies not only in the United States, but in Europe, Australia and Canada. “Big public funds were early adopters on each of the major continents.” He noted also the size of those commitments: “For organizations of this size, dipping a toe in means $2 billion or $3 billion—that’s pretty impressive that the biggest players are trying it.”

Does Smart Beta Actually Work?

In a 2005 paper by Arnott and colleagues Jason Hsu and Phillip Moore, they concluded that “if the goal of earning higher returns with lower risk is the raison d’être for the finance community, the evidence for indexing to these fundamental indexes is convincing.” Using fundamentals like book value, revenues, dividends and others, the researchers concluded that “the resulting portfolios outperformed the S&P 500 by an average of 1.97 pps [or 197 basis points] a year over the 43-year span tested. The performance was robust across time, across phases of the business cycle, across bear and bull stock markets, and across rising- and falling-interest-rate regimes. Our work suggests that indexes constructed using Main Street measures of company size are significantly better than the cap-weighted Wall Street indexes.”

Additional research, such as an article in the September-October 2011 issue of the Financial Analysts Journal by four Research Affiliates authors—Tzee-man Chow, Hsu, Vitali Kalesnik and Bryce Little—back-tested a number of smart-beta strategies and concluded that there is clear “empirical evidence that the popular alternative betas outperform cap-weighted indexing.” However, they also concluded that “the performances are directly related to a strategy of naive equal weighting, which produces outperformance by tilting toward value and size factors.”

The authors provide one other caveat: “We caution investors to pay special attention to the potential implementation costs of these alternative betas relative to the cap-weighted benchmark” since a number of factors, including “fees and expenses associated with managing a more complex index portfolio strategy, may erode much of the anticipated performance advantage.”

In a presentation at Morningstar’s ETF Invest conference last year, Arnott reiterated his team’s research into whether smart beta actually works. Testing how five popular smart-beta strategies would have performed from 1964 to 2012, a cap-weighted strategy would have produced a 9.7% return over that period, while each of the smart-beta strategies added at least 2% more to the return numbers. Then his researchers decided to “flip the strategies on their heads,” reversing the weight of all the holdings in the fundamental strategies; the outperformance held. His conclusion: Smart beta outperforms because it breaks the link between price and weighting in the portfolio.

Never one to shy away from informed critiques of his work, Arnott said that the early critics of fundamental indexing said it was “only a clever repackaging of value strategies.” He admitted that “it does have a value tilt, but it garners only a quarter from value, the rest from the contra-trading,” since smart-beta strategies consistently trade against price movements, which allows these strategies to “capture the opportunities presented by mispricing.” Research Affiliates’ research shows that “long-term mean reversion in the form of value and size premium explains the majority of the smart-beta value added.” Moreover, Arnott pointed out that “value has underperformed since 2005; it’s been terrible [...] and yet fundamental index has outperformed—it’s the rebalancing alpha with its relentless, systematic value add.”