Ferri Vs. Arnott: Is Smart Beta Real?
It seems that the concept of so-called “smart beta” ETFs is catching on, as investors embrace the prospect of higher rates of return—even if often for a higher fee than comparable market-cap strategies—in a growing wave of popularity that people like Research Affiliates’ Rob Arnott are riding.
The lineup of funds using so-called fundamental indexes from Arnott’s firm that organize portfolios around factors, including book value, cash flow, sales and dividends, instead of simply weighting a portfolio’s holding around market price, have grown to $100 billion in just 10 years.
Fund sponsors, notably Invesco PowerShares and most recently Charles Schwab, are aggressively marketing funds using Arnott’s indexes. Another ETF firm, WisdomTree Investments, has built its entire brand around a growing lineup of self-indexed fundamental funds that cherry pick securities based on dividends and earnings.
These fundamental strategies stand in contrast to the still prevalent market-cap-weighted strategies that are based on the price of a security—the higher a stock price goes, the bigger its weight in a portfolio.
“Fundamental strategies break the link with price and have historically delivered excess returns relative to market-cap equivalents,” said Tony Davidow, vice president of Alternative Beta and Asset Allocation Strategist at Charles Schwab, last month at the time of the firm's rollout of fundamental ETFs. Schwab’s lineup of six fundamental ETFs has accumulated some $22 million in little more than two weeks since inception.
So, what’s not to like about the idea that smart beta ETFs are, well, smart?
It depends on whom you ask. As Michigan-based Portfolio Solutions’ Rick Ferri would say—tongue in cheek—who would want “dumb-old beta” when you can get the smart, the better, the alternative version of beta that delivers—at least in back-testing—higher rates of return relative to the broad market.
The problem is that beta is just beta, at least according to Nobel-prize winner economist Bill Sharpe, who coined the concept decades ago when he developed the Capital Asset Pricing Model (CAPM) of modern portfolio theory. As Sharpe explains it, beta is simply a portfolio’s sensitivity to movements in the overall market.
“How do you get smart out of that?” Ferri told IndexUniverse. “It’s neither smart, nor alternative, nor better. It just is.”
“I am perfectly comfortable with Rick’s view,” Arnott said in an interview with IndexUniverse’s Managing Editor Olly Ludwig recently. “My view on this is that it’s all about semantics and definition of the terms.”
As Arnott sees it, purists like Ferri view beta from a CAPM perspective, in which case in order for something to be an index, it necessarily needs to be market-cap-weighted. That, in turn, means that benchmarked funds also have to be cap-weighted market portfolios.
“And for it to be a measure of beta, it has to be based on the cap-weighted market,” Arnott added. “To them this is an active strategy. It’s not beta, it’s not smart beta; it is just a strategy.”
“From my perspective, I think that that’s a narrower definition of ‘index,’ and a narrower definition of ‘beta’ than is common usage in our industry today,” Arnott said. “My own view is that people measure beta of portfolio against stocks, against bonds, against factors; so why not against fundamentals?”
Our annual fixed-income conference is coming up in a little more than a week and I can’t wait.
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