'Smart-beta' returns come from excess risk, not from some magic alpha.
This blog is the fifth installment of a series transforming our ideas about "smart beta." Part 1 started with the proposition that defining smart beta in an ETF context is essentially impossible. Part 2 laid out the ground rules to prove the point; Part 3 sunk noncap weighting as a method to categorize smart beta; and Part 4 took a wrecking ball to the notion that factor-focused tilts were synonymous with smart beta.
Wear black today, because we’re going to a funeral. I’m going to bury the term “smart beta” for good.
I’ve been preparing you for this grim end with a series of blogs in which I’ve proven, step by step, that there’s no definition for smart beta that works consistently in an ETF context. I’ve saved the death blow for today.
In the ground-rules blog—No. 2 in this series—where I explained what a definition of smart beta should do, I listed seven possible definitions of smart beta. Then I started showing why each of the seven fails to meet basic ground rules.
Today I’ll take on the last two: superior risk-adjusted returns; and improved diversification.
No. 7, diversification, is a mere trifle. I’ll save it for the end of this blog for my most-patient readers. I know you’re all dying for me to dive in to the real heart of the matter: excess risk-adjusted returns. So let’s get to it.
The seductive promise of active management—that your “above-average” manager comes from Lake Wobegon and can consistently produce risk-adjusted outperformance—has invaded the world of passive investing in the form of smart beta. Why else would anyone go to the trouble and expense of rearranging a plain-vanilla index?
In the world of investments, the holy grail, the big payoff, is excess risk-adjusted returns. If a strategy—active or passive—produces more returns than it ought to given the risks taken, then it’s a home run. Like the owners of the New York Yankees, investors are willing to pay dearly for the possibility of a free lunch. (Can you tell I’m a steeped-in-“Moneyball” Oakland A’s fan?)
Even Morningstar, acknowledging the spirit of smart beta, is now categorizing what it calls “strategic beta” strategies according to whether they promote outperformance or promise risk reduction. Morningstar’s researchers know damn well to evaluate performance and risk jointly (see under: Five Star fund).
So, what they’re really saying is that smart-beta funds promise outperformance with no increased risk, or at least, normal performance with reduced risk. Either way, this adds up to promising risk-adjusted excess returns.
Anyone—even my Uncle Milton—can promise that a strategy will produce risk-adjusted outperformance. But can they deliver? My Uncle Milton is long gone, but smart indexing is on a roll, gathering assets and lots of press. These smart-beta funds have left behind a performance record. So there’s something we can test. Shall we?
A first-rate ETF database, fund marketing material and some statistical know-how are all we need to find out how these strategies have lived up to their promises.
I used ETF.com’s database to test 11 widely held U.S. large-cap ETFs with complex strategies, whose marketing material suggests these funds will outperform on a risk-adjusted basis.