Maybe a rose by any other name would smell as sweet, but slapping the label “rose” on a skunk would not improve the impression the small mammal makes on those in proximity to its scent.
And that is the problem with the widely used new term “smart beta,” which generally has a positive connotation in the investment world but which is increasingly being applied to products with a rank smell — perhaps at least to Rob Arnott, whose firm, Research Affiliates, is most identified with smart beta.
In a newly published essay, Arnott, together with Research Affiliates senior researcher Engin Kose, wades into the fray on the true meaning of smart beta, which he views as “one of the most overused, ill-defined, and controversial terms in the modern financial lexicon.”
While Research Affiliates’ smart beta products have been commercially available now for close to 10 years, Arnott has perhaps been circumspect about defining a term that he makes clear was not his own invention.
So why speak up now?
“The success of so-called smart beta products has attracted a host of new entrants purporting to be smart beta products when, frankly, they aren’t!”
The fact that his own smart beta products — once derided as repackaged value investing based on back-tested data, he recalls — are just shy of 10 years of live data demonstrating their outperformance relative to cap-weighed indexing also suggests the need for a concrete definition of the strategy that has produced these results.
For starters, smart beta should not be understood as merely something other than traditional cap-weighted indexing. In fact, Arnott and Kose gallantly defend the rival indexing approach from charges that it is “dumb beta.”
“If an investor wants to own the broad market, wants to pay next to nothing for market exposure, and doesn’t want to play in the performance-seeking game, cap-weighted indexing is the smartest choice, by far,” they write.
Respectfully acknowledging the integrity of this strategy, Arnott’s worry seems to be the “me-too firms” that want to “stamp smart beta on anything that’s not cap-weighted indexing.”
Towers Watson, the investment consulting firm that coined the term smart beta, last year sought to add clarity to the term by defining it as “good investment ideas … structured better,” adding that such strategies should be “simple, low-cost, transparent and systematic.”
Arnott and Kose want to build on that definition, specifically with respect to equities. Here is their definition:
“A category of valuation-indifferent strategies that consciously and deliberately break the link between the price of an asset and its weight in the portfolio, seeking to earn excess returns over the cap-weighted benchmark by no longer weighting assets proportional to their popularity, while retaining most of the positive attributes of passive indexing.”
This definition enables them to sharply contrast their approach to that of cap-weighted portfolios, whose indices are linked to price and therefore “automatically increase the allocation to companies whose stock prices have risen, and reduce the weight for companies whose stock prices have fallen.”