The two terms are often used interchangeably, but that approach overlooks important nuances. And by missing those nuances, advisors and investors could be making some costly errors by their lack of understanding.
Rob Arnott, founder and chairman of Research Affiliates, said the term “smart beta” was coined by London-based consulting firm Towers Watson in 2007, and the inspiration was fundamental weighting. That strategy works by trimming positions in companies whose price is rising but their fundamental value isn’t changing, and buying companies whose prices are falling but their fundamentals remain the same. By breaking the link with price, it forces the index to rebalance against the market’s most extreme bets, he says.
“They said, ‘that's smart. We should tell our clients to diversify their core risk … and split their money between index funds and one of these smart-beta strategies,’ Arnott said. “Well, the term became popular because pretty soon everybody was wanting to say ‘we're studying smart beta.’”
Factor investing, meanwhile, was focused on academic work by University of Chicago professors Eugene Fama and Kenneth French (now at Dartmouth), as an asset pricing model, with Mark Carhart of the University of Southern California expanding on their work with his own model. There are five main factors associated with higher returns that are widely used in factor ETF strategies: value, small-caps, momentum, low volatility and quality (which is also known as dividend payers). A sixth factor, yield, is sometimes included in the main factor definition count.
Arnott says that since fundamental weighting has a value tilt because it’s always buying out-of-favor companies, the factor community embraced the term smart beta. And this may be where some of the blending of the two terms may have occurred. But Arnott says because factor investing begins by using a market-capitalization weight and then adds a factor tilt, it isn’t smart beta.
“There's nothing about factor tilts that make them smart beta under the original definition, but I've lost that fight,” he said. “The marketplace now says factor strategies or smart beta. I disagree, but I don't define the semantics of our industry.”
Sal Bruno, chief investment officer of IndexIQ, agrees that, as smart beta has evolved, the term itself has been stretched. “I think they get conflated because it's sort of everything that's not market-capitalization weighted kind of gets thrown into this smart-beta definition,” he said, noting some other terms like “alternative weighting” or “alternative beta.”
Factor investing itself has become stretched beyond the Fama-French research, and Bruno says that’s a problem. The original factors have the name of the factor embedded in research, such as “high minus low,” showing that it was long one characteristic and short another to become neutral to the market, he notes.
“The pure factor is important from a research and academic perspective, because if you don’t do that, you end up including too much of the market effect, which is its own factor,” Bruno added.
Mike Venuto, chief investment officer of Toroso Investments, says defining what a factor is and what it isn’t may have also led to confusion. There are the original Fama-French factors, but some people are using nonacademic definitions—such as environmental, social and governance tilts or share buybacks—and calling them factors. Some of those may not have as rigorous research, but he says they still may might be considered factors.
Mark Carver, executive director, Americas index products at MSCI, says that from a practical standpoint, factors look at characteristics that help investors understand the behavior of an asset. Factor portfolios are generally thought of as a long/short portfolio, where the investor is long equities that have high exposure to the factor and short equities that have low exposure to the factor, and the factor return is the difference between those two.
Smart beta is usually long only and weights by company fundamentals.
Carver also doesn’t care for the term smart beta from a semantic standpoint since “that assumes there's an opposite to that which would be dumb, but we would strongly disagree with that idea. There’s just beta.”
Another way he sees factors as different from smart beta is when it comes to creating indexes. MSCI, which has studied factors for more than 40 years, tries to isolate specific characteristics, Carver says, and organizations like MSCI have a set of factors they think earn a reward over time, such as value, momentum, quality, size, etc.
“We're building indexes against those factors that have a lot of empirical evidence that they earn a reward over long periods of time, and that’s different than what you're doing in smart beta, which could be just trying to get a thematic idea that may or may not hold up to long-term rigorous evidence,” Carver said.
Some fund issuers mix fundamental weighting with a factor, blending the two concepts. When that happens, it can be hard to separate out what’s contributing to performance.
“I calculate there are 62 [ETFs] focused on the value factor. And how do I evaluate one versus the other, and which one do I figure out is right for my portfolio? That's the big question,” Venuto said. “Considering the limited resources out there, I don't know how people are answering it.”
And Bruno says factor investing that seeks to be market neutral by going long one factor and short another may not give as much return as the hype around it would lead you to expect. The absolute return from spread between the factor may only be 1-2%, while the actual market supplies the rest of the return.
“The predictability is difficult,” he noted. “If it were always positive, that spread would be fantastic enough: 2% on uncorrelated data returned to market would be the holy grail. The problem is we don’t know when value will outperform growth [for example].”
500+ Supporting Papers?
While factor investing may have a lot of history behind it, Arnott famously pointed out two years ago in his research paper “How Can ‘Smart Beta’ Go Horribly Wrong?” that there is a lot of data-massaging to prove factors work. He says there are more than 500 papers that were published by the end of 2016 showing factor investing worked. But he thinks those papers missed an important point.
“Not a single one of the 500 papers asked the question, did we win because we had a tail wind from rising valuation because our strategy was getting more expensive?” Arnott said. “Anything that's newly expensive, I guarantee you is likely to have wonderful past returns.”
“There's the selection bias that publishing factors means you're self-selecting to factors likely currently overpriced, that are likely to work much less well than in the past… ,” he added. “A stock can get very expensive, and if there's any mean reversion, it could tumble. The same holds true for strategies. The same holds true for factors.”
Arnott also has issues with the multifactor strategies that blend two or more factors and tout that doing so smooths out the ride for investors, which he says is “a gross oversimplification. I think if you use a multifactor approach, some of the factors have merit, some of them were discovered based on noise … but you don't know which is which, so using multiple factors increases the likelihood that you'll have one or two factors that actually do work to smooth the ride.”
He’s not against factors per se, but says that fundamental weighting to buy cheaper companies can give factors more oomph. “We know that factors when they're trading cheap have high odds of success and when they're trading rich have very low odds of success,” he pointed out. “Why not be dynamic about it? Why not emphasize the factors that are trading cheaper than usual right now?”
Arnott’s firm provides the indexes underlying PIMCO’s dynamic multifactor ETFs.
Smart Beta Vs Factors:
What Is Smart Beta?
- Smart beta ranks companies by their size rather than by their market capitalization
- When creating an index, the company’s size is used as an anchor to determine its weighting; that weighting is rebalanced if prices move extravagantly
- If a company’s price is soaring but the fundamentals of the company have changed, the index will trim the position; if the prices fall and the fundamentals haven’t changed, the index buys the stock.
- Takes into account alternative ways to measure worth, e.g., volume, liquidity, momentum
- Sometimes called equal weight, fundamental weight, alternative beta
- No single approach
- Usually long only
What Are Factors?
- An asset pricing model created by University of Chicago professors Eugene Fama and Kenneth French (now at Dartmouth)
- Fama and French found 5 main factors are associated with higher returns: value stocks, size momentum, low volatility and quality (also known as dividend payers); A 6th factor, yield, is sometimes included in the main factor definition count
- Different factors work during different times in the market cycle, but they can’t be timed
- Usually a long/short strategy
- Usually market-cap weighted, but can be used with fundamental weighting
- Nontraditional factors such as share buybacks, and environmental, social and governance tilts are becoming more popular as factor investing grows in use