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.