Smart beta is all the rage, but that doesn’t mean cap-weighted indexing is dumb, S&P’s Lazzara says.
Being an index provider in an era of enormous demand for anything from “smart” beta to factor-tilts to plain outside-the-box index strategies requires ingenuity and a lot of work. Craig Lazzara, global head of Index Investment Strategy for S&P Dow Jones Indices, and one of the brains behind the wildly popular S&P 500 Low Volatility Index, would know.
In a recent interview with IndexUniverse’s Cinthia Murphy, Lazzara said that the so-called third generation of indexes is upon us, and it will involve a lot of nonmarket-cap-weighted strategies. It’s too soon to tell whether all these smart-beta strategies are truly superior to cap-weighted index methodologies, but there’s no doubt that, for now, they're becoming all the rage, Lazzara says.
IU.com: Where do you see the biggest client demand when it comes to index innovation these days?
Craig Lazzara: The way to think about this is to think about the evolution of the index business. Thirty years ago, all the indices that existed were kind of large-cap, typically cap-weighted, typically designed to replicate the entire asset class. Think the S&P 500, the Russell 1000—they fit that description.
That was the first generation of indices, and that’s how the index business and index funds started. And ETF funds were started that way as well.
The second generation would be extensions and subdivisions of the first generation. Indices like the S&P 500 spawns S&P 400 MidCap, S&P 600 SmallCap; Russell 1000, Russell 2000, and so forth. And then subdivisions, sectors, industries, growth and value and typically cap weighted and designed to represent a subset.
The third generation, which is where we are now, and are only beginning to develop, is what people call "smart beta"—which is a term I despise, by the way, because to say that the third generation is "smart beta" implies that the first two generations were dumb.
IU.com: So smart beta is where index evolution has taken us?
Lazzara: More to the point on the smartest things a financial advisor can possibly do for his clients, or an individual investors could do for himself, is to make a very large allocation to cap-weighted indices. Over time, cap-weighted indices have outperformed, depending on which category, 60 to 70 percent of all active managers—as you can see in the SPIVA reports. That idea sounds pretty smart to me.
But that’s my animus towards the term "smart beta." I like to call it "factor indices" or "strategy indices." And the notion there is, instead of trying to replicate an asset class or a subset of an asset class, the question is, can you replicate a pattern of returns that investors might find congenial?
Take, for example, the S&P 500 Low Vol index. The the question was, can you specify a set of rules that will let you extract stocks from the 500 in such a way that the stocks you pull out are consistently less volatile than the parent you started with? The answer was yes, you can do that. And that pattern of returns—less upside but less downside—is something that many investors find very congenial.
There’s a companion, almost the evil twin of low vol called "high beta," which is designed to do almost the exact opposite: to go up more and to go down more—again, a pattern of returns that some investors find congenial. So it’s that kind of search for return patterns that I think defines that third generation of indices, typically not cap-weighted.
IU.com: At what point does factor investing or smart beta investing become active investing?
Lazzara: When it ceases to be rules based, in the sense that if you can write down a set of rules, all of which are publicly disclosed, to come up with an index so that anyone could look at your website or look at the ETF providers’ website and be able to replicate that. In this case, the element of human judgment in it is to say that these rules make sense. That’s an index.
If you take a step beyond that and say, well, of all the 100 least volatile stocks in the S&P 500, I don’t like these three, now that’s an active decision. So as long as it’s rule based, I think it qualifies as passive. As long as the rules are clear and transparent, I think it’s fair to say that’s an index as opposed to an active portfolio.