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June 19, 2014 at 08:42 AM
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.
