Smart beta makes me nervous. Year after year, S&P Dow Jones Indices publishes a scorecard showing what percentage of actively managed funds outperform their most-suitable benchmarks. SPIVA (the S&P Indices Versus Active Funds (SPIVA) Scorecard) documents the widespread underperformance of actively managed mutual funds relative to cap-weighted benchmarks in virtually every asset class and every time period. Fees contribute to this underperformance, but don’t explain all of it. Smart people’s best efforts at outperforming have failed.
The documentation of the failure of active management is thick and convincing. The December 2012 SPIVA report showed 56 to 80 percent of actively managed funds trailing their S&P asset-class index’s 12-month returns in all equity categories, U.S. and global, except for one (Figure 1). Over a five-year period, between 50 to 92 percent of U.S. equity funds and 21 to 75 percent of global and international equity funds trailed their S&P benchmarks (SPIVA U.S. Year End 2012 Scorecard). Only international small-cap funds significantly outperformed the S&P benchmark. Further, in 2010, Cuthbertson et al. found that no more than 5 percent of U.K. and U.S. equity or bond mutual funds have positive alpha. 1
Worse, there seems to be little or no persistence—outperforming managers tend to underperform in subsequent periods. SPIVA’s 2012 persistence report2 found that, over a five-year period, virtually no (0.1 percent) top-quartile managers stayed in the top quartile. One would expect 25 percent of them to do so by chance alone, and more than 25 percent if past performance predicted the future. Cuthbertson et al. found persistence only for those managers who rebalance frequently and regularly update their forecasts, taking prior assumptions as a base and changing as new information becomes available. A June 2013 white paper by Ferri and Benke suggests that security selection is not working for actively managed funds.3 The authors found that, while sticking to actively managed funds with expense ratios in the bottom half of their group reduces underperformance relative to index funds, actively managed portfolios underperformed equivalently weighted index fund portfolios between 70 to 90 percent of the time.
Now there is “smart beta,” a series of rules-based indexes that claim to deliver superior returns over the long term without corruption by human decision-making, at a reasonable cost. Some smart beta providers even suggest that their products stand a good chance of producing superior risk-adjusted returns over a full market cycle. Can smart beta succeed where active management has failed?
Smart beta substitutes a set of rules for active investment’s teams of expert stock pickers. Given the frailties of human investors, perhaps a well-crafted rules-based product can succeed where mere mortals fail.