‘Smart Beta’ Looks Like Expensive Beta

June 08, 2015

This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today’s article features Dan Egan, director of behavioral finance and investing at the New York-based automated investing service Betterment.


With high-fee active managers and hedge funds in decline, and technology lowering much of the cost of day-to-day investment management, how can a fund manager justify a higher-margin product?


Judging by the past, such a product would likely play on consumers’ desire to beat the market, without trading off liquidity, concentration or opacity risks.


Enter “smart” beta funds, the newest in a long line of investment funds offering the possibility (not the guarantee) of higher risk-adjusted returns compared with the market. The investment decisions of these new funds aren’t based on gut feel and the networking ability of a human advisor, they use quantitatively designed algorithms.


They are often marketed based on hypothetical historical data regarding various factor risk premia. They cost up to 600 percent of similar normal-beta ETFs. And they are growing quickly.


But, are they good for investors?


So far, the answer is no.


Market Capitalization: Still The Anchor

The starting point for any allocation model is a market-capitalization-weighted portfolio. By anchoring to market capitalizations, you free-ride on the collective wisdom of millions of investors and traders globally. You also know how much you are diverging from market allocation; that divergence is the foundation for generating outperformance.


The same logic can also inform portfolio construction for clients who want to take on more or less risk. While the market holding of U.S. small-caps, for instance, reflects the risk that investors on average are willing to bear, individual investors may be comfortable with more or less risk in their portfolio. It is up to the individual advisor to determine how to take on more or less risk while maintaining a diversified portfolio.


The cleanest way to do this is to use the global market as a benchmark for determining asset allocation. Allocations should consider the market value of available assets, and the implied expected returns from those assets should guide a proportional allocation to the different markets. This was the insight behind the pioneering work of Fischer Black and Robert Litterman in creating the Black-Litterman model for creating diversified portfolios at every risk level.


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