‘Smart Beta’ Looks Like Expensive Beta

June 08, 2015


A Negative Risk Premium?

The core principle of all investing is earning a risk premium.

If you’re bearing uncertainty, you should be able to demand to be paid more, especially net of fees and taxes. Smart-beta funds appear to be based on the opposite notion; namely, that the investor should bear known higher costs—management fees, transaction costs and tax costs—in exchange for the very uncertain chance that active indexes will outperform on average and over a long period of time.


And it’s far from certain that documented historical performance by smart-beta factors will persist.


A recent paper by McLean and Pontiff in the Journal of Finance reviewed the persistence of such premiums out-of-sample (not based on backtests) and after publication of the premiums. They find that portfolio returns are nearly 30 percent lower out of sample, and 60 percent lower post-publication. That’s market efficiency reducing the effectiveness of known risk premia.


So, as it was before the growth of smart-beta funds, market-cap-weighted indexes are probably still the worst way to invest, except for all those others.

At the time of writing, Betterment did not own any of the securities mentioned. Betterment is the largest, fastest-growing automated investing service, helping people to better manage, protect, and grow their wealth through smarter technology. It is a CNBC Disruptor 50 and Webby award winner and has been featured in the New York Times, Forbes, and the Wall Street Journal. Learn more here.



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