If every idea has its time, the intellectual respectability and volume of assets flowing into so-called smart beta suggests its time is now. But will the alternative indexing scheme endure or fade from the scene? In other words, is smart beta really better beta?
That was the question debated at the Morningstar Investment Conference Thursday morning by two eminent authorities on indexing: Chris Brightman, chief investment officer of Research Affiliates, which more than other firm has popularized smart beta through its RAFI and other indexes; and financial advisor Rick Ferri of Portfolio Solutions, an early champion of exchange-traded funds and longtime advocate of low-cost passive indexing.
The two heavyweights in their respective camps came out slugging:
“Over the 10 years since we’ve launched, the live results have been completely in line with the historical studies…That has attracted the attention of asset managers everywhere who all want to jump on the bandwagon and get into this alternative space,” said Brightman, who touted the strategy’s 2% return advantage over standard market-cap-weighted indexing.
But Ferri was having none of it, and warned against drawing premature conclusions from recent market experience.
“Well, it has been smart over the last 15 years; but it’s probably been the best 15 years you could have ever picked because you would have outperformed no matter what you did. But how it will do over the next 15 years?”
Softening his target with the initial blow, the former Marine attempted an early knockout by attacking the now popular strategy’s very essence:
“I don’t know what smart beta is,” Ferri said, defending the efficient market idea that makes a virtue of ignorance of what will perform well or poorly.
“We don’t know what smart is, and I’d be surprised if 10% those going around saying ‘smart beta,’ ‘smart beta,’ know what beta is. ‘Smart beta’ is a marketing phrase.
Then, aiming for the final blow: “Smart beta is defined by me as anything that’s not beta.”
But Brightman was no pushover. By conceding in non-vital areas, he asserted a strong defense over the core basis of his smart beta approach.
“None of these are magic strategies that are going to outperform every year,” Brightman said, “There will be uncomfortable periods of underperformance for any strategy.”
But he defended what he called the simplicity and transparency of weighting indexes according to criteria such as sales and book value and then rebalancing annually in order to sell companies that outperform and buy companies that underperform.
Such an approach provides an advantage to market-cap-weighted indexes that inherently favor larger, more popular stocks simply because the higher prices magnify their importance in the index.
“If you don’t believe in long-term mean reversion and think that markets are perfectly efficient … then don’t invest [in smart beta]. If you do believe in it, stick with it,” Brightman said, adding that investors’ return-chasing behavior is precisely what provides a return advantage to those who do stick with the strategy.
To Ferri, the theory behind smart beta could not withstand what he saw as three real-world disadvantages: the cost of implementing the strategy, its risk, and what he deemed the probability of capitulation of ordinary investors lacking the patience to see it through periods of underperformance.
“The cost of beta is basically free — you can get it for 5 or 6 basis points. Everything other than beta is more costly — on the average of 60, 70 or 80 basis points. That’s a high hurdle rate,” he said.
Then, citing Eugene Fama, he said that the “smart” aspect of selecting stocks that might generate higher returns inherently means adding more risk. This is problematic, he said, because “there are very long periods of time that these strategies can underperform the market,” citing an 18-year period where value underperformed.
“Are your clients going to hang in there for 18 years?” Ferri asked. “Probably not.”
That’s when Brightman started slugging, attacking Ferri’s core assumptions.
“Let’s start w/ the assertion that return comes from risk. That’s not a fact — it’s a theory. That’s Eugene Fama’s theory; most research would suggest that [return does not come from risk].”
The Research Affiliates chief investment officer insisted that fundamental indexing is not a small-cap value strategy, emphasizing that his firm’s indexes include large companies like Exxon, Google and Apple as well. “We just weight them a little more carefully,” he said.
Now Ferri politely gave a little ground, admitting he liked the PowerShares FTSE RAFI Small-Mid ETF, while jabbing back with his principal objection:
“More choices are great but…what are we paying for and what are we getting? Does it have a tilt? Yes, but it’s not a strong tilt, and I’m paying another 50 basis points,” Ferri said, restating his general preference for Vanguard ETFs costing 15 basis points.
Ferri maintained his pugilistic stance on costs throughout, arguing that even if investors could obtain a risk premium, that premium “could be zero or less over the next 15 years.”
Brightman, though, lamented all the talk about risk premiums, arguing for the value and discipline of buying “when a 2008 comes around,” which smart beta’s rebalancing requires. “That’s like buying [Russian oil producer] Lukoil today. Does that feel like a comfortable trade? No. It means selling Internet stocks in the late ’90s, buying emerging-market resource stocks today.”
Citing his 25 years in the business, Ferri said that experience tells him of smart beta’s current popularity that “when everybody tries to do something, it’s usually not a good time to do it.”
While neither combatant fatigued during their slugfest, Ferri sarcastically appointed the government as referee in a concluding line that had the advisor audience and Brightman laughing.
“The Securities and Exchange Commission has called these [smart beta products] indexes,” he said. “Since the government calls it an index, it’s an index.”
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