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Portfolio > Portfolio Construction

Smart Beta’s Low IQ

By Gil Weinreich

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Smart beta seems to have lots of fans these days, and the indexing strategy’s detractors are generally less audible.

Not so Ron Surz, a veteran index creator, who is particularly critical of PowerShares’ Fundamental Pure Style (FPS) indexes.

“When you value-tilt a growth index, you just turn it into another value index. That kind of fundamental weighting is, well, stupid,” he tells ThinkAdvisor in a phone interview.

The ThinkAdvisor contributor and president of Orange County, California-based pension consulting firm PPCA finds fault with his cross-county rival Research Affiliates’ propensity to tilt toward small-cap and value stocks.

He admits that weighting has outperformed in the past, but says “it’s not a slam-dunk guarantee of better [future] performance.”

Citing Research Affiliates founder Rob Arnott’s dictum about weighting an index by anything other than price, Surz asks rhetorically:

“So why don’t you weight by earnings growth?”

In other words, smart beta shouldn’t have to be value-oriented, as Arnott’s indexes are, in order to break the link between price and weight to which both indexers object.

And it is PowerShares’ FPS indexes that epitomize to Surz how smart beta flunks the investment IQ test.

“The large-cap growth portfolio is right on top of the large-cap value in terms of its characteristics [i.e., they’re essentially the same],” he says.

“The mid-cap growth portfolio is more defensive than the mid-cap value fund, and it’s the same story with the small-cap growth portfolio, which has a lower P/E than the small-cap value portfolio,” he says.

Smart beta has “made a mush of the growth indexes,” he adds.

The veteran indexer discloses a personal history involving the contrasting approaches he and Arnott take and PowerShares.

“I was actually having conversations with PowerShares seven years ago,” he recalls. “They already had style indexes that were not attracting assets, and they decided they needed to change the game.”

After thoroughly vetting Surz’s indexes, “they went with Arnott, trying to capitalize on smart beta; it was hot. He built it for PowerShares. The bottom line: it’s marketing; it clearly wasn’t thought through,” Surz says, referring to what he views as the lack of differentiation among the style indexes.

As to his own indexes, the PowerShares exec said “nobody knows about [them]; we can’t sell those.’”

Despite their different approaches, Surz agrees with smart beta’s rejection of the cap-weighted and other conventional indexes such as S&P 500 as not very smart.

A key reason relates to how broad market indexes are used in portfolios by active managers.

“Many people are using the S&P 500 as [the core part of] core-satellite,” Surz says.

“Think for two minutes what that does. The S&P 500 is bringing instant dead weight that that active managers don’t want — you’ve watered down the active growth manager’s portfolio with 200 stocks he doesn’t want to hold. Now you’ve undermined his alpha.

“You’ve lowered your portfolio costs with this low-fee index,” he continues, “but at the end of day, you’re penny wise and pound foolish.”

Surz cites the Russell 1000 indexes as exemplifying the problem.

“Some stocks are growth, no doubt about it; some stocks are value, with high dividends and low P/Es,” he says. “But in between the two extremes there’s a fuzzy area. Out of the Russell index’s 1000 stocks, 330 stocks are both value and growth. They dealt with the stuff in middle by saying it’s fair game for both value and growth.”

S&P’s historical indexes have the same problem, though the index creator has recently sought to rectify it with newer “pure” value and “pure” growth indexes.

“They’re saying ‘we’re gonna throw out the third in middle,’” Surz says. “But now they’ve now discovered they’ve got an Oreo cookie without filling.”

Surz has taken an altogether different approach, offering the creamy filling, a portfolio he calls “Centric,” which he says allows active managers to use an undiluted core portfolio while seeking alpha on their own.

“Subtracting the small and the value — that’s smart because it avoids the [parts] the active managers don’t like. It allows for better completeness. It’s truly a disruptive innovation,” he says of the Centric index he developed in the 1980s.

“You get as much diversification with a spoonful of Centric as with a handful of S&P 500,” he adds.

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