Research Affiliates: The Promise Of Smart Beta

January 23, 2015

When I think about the original index fund, the promise to investors was clear: a transparent, low-cost, low-governance, high-capacity strategy for accessing the equity risk premium through cap-weighted exposure to market beta. For investors who are under pressure to reduce expenses, who have limited resources for selecting and monitoring active managers, who have extremely large assets, or who have lost faith in active management, the first index mutual fund and its many offshoots delivered on that promise. They provided a portfolio that, over the long horizon, outperformed the average active manager (especially on a net-of-fees basis) while requiring almost no attention. No stock stories, no brilliant but idiosyncratic portfolio managers—and no need for the beauty parade that we call manager selection. Emotionally, index investing deprived clients only of the illusion of control, and in exchange for that trivial sacrifice it entertained them with the daily ups and downs of the market as a whole.

Finance theory and knowledge has advanced tremendously since Vanguard launched the first index mutual fund in 1976. We now know that there is more than just the market factor that generates an equity return premium over time. Eugene Fama won the Nobel Prize in Economics, in part, for demonstrating that there are three reliable sources of equity return. Today the Fama–French three-factor model, or some variant of it, is used by nearly every quantitative analyst to examine equity returns. Robert Shiller won his Nobel Prize in Economics for arguing that investors’ enduring behavioral biases can generate persistent anomalies in the financial market that can be exploited for outperformance. The literature today is populated by evidence that value, momentum, and the low-beta anomaly are rooted in investors’ behavior.

Exactly 40 years later, what would a challenge to our industry like Paul Samuelson’s mean? The frontier academic knowledge has changed—there are multiple “betas,” not just the market beta, that provide persistent premia over time. But some things have remained the same. Costs always erode investors’ returns and skilled stock picking is unnecessary for successfully investing in these alternative equity betas.

I wish for smart beta to be 2014’s answer to Samuelson’s challenge just as Vanguard’s first index mutual fund was the answer in 1974. We know how to design simple, low-turnover, and well-diversified core-like portfolios that access the premia associated with the various known equity return factors. Through the index chassis, which requires systematic and rules-based portfolio construction and thus promotes transparency, we can lower governance cost and reduce investment management expenses. When designed properly, smart beta strategies can be the prime alternative to active management for our times just as cap-weighted index funds served so admirably in that role for the past four decades.

I would be saddened if the allure of gathering assets causes providers to allow smart beta to deteriorate into the deception of “backtest alpha.” I hope for a far better outcome. I hope smart beta shakes up the business-as-usual world of investment management. I hope smart beta funds pull assets away from closet indexers and the high-load, high-fee active products that survive, through effective advertising, at the expense of investors. Finally, I hope this disruptive new entrant goes on to transport index investing from the one-factor thinking of old to the multi-factor framework of modern finance. That is the promise of smart beta for me as an investor and an academician. As an asset manager, I pray that my firm and I have the courage to deliver on the promise of smart beta just as the pioneers of indexing did 40 years ago for the cap-weighted market beta.

Endnotes

  1. 2% + 20% (“two and twenty”) means a flat fee of 2% on assets under management plus an additional 20% of gains.
  2. “Optimized backtests” sell better irrespective of their actual relationship to future performance.

References

Bogle, John C. 2014. “Lightning Strikes: The Creation of Vanguard, the First Index Mutual Fund, and the Revolution It Spawned.” Journal of Portfolio Management, vol. 40, no. 5 (Special 40th Anniversary Issue):42–59.

Samuelson, Paul A. 1974. “Challenge to Judgment.” Journal of Portfolio Management, vol. 1, no. 1 (Fall):17–19.

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