By the early 1970s, the finance literature had already documented that the average mutual fund consistently underperformed the market index, net of fees. The literature also demonstrated that a diversified “market” portfolio would naturally earn a positive equity risk premium without the help of a skilled stock picker. Armed with these academic findings, Paul Samuelson (1974, p. 18) challenged investment practitioners to consider creating investment portfolios that track the S&P 500 Index.
Samuelson’s short article struck Jack Bogle (2014, p. 42) “like a bolt of lightning.” Recounting the early history of Vanguard, Bogle identifies Samuelson’s challenge as a major impetus for the creation of the first index mutual fund. Vanguard’s low-cost index funds, to me, were born out of a deep awareness of the academic literature and a deeper concern for the welfare of the end-investor. Nothing in our industry has so inspired me.
As a champion of smart beta and a spokesperson for Research Affiliates, which regularly debates Vanguard on the definitions of “beta” and “index,” I am unlikely to be confused for a “Boglehead.” However, I have the highest respect for Jack Bogle’s contributions. In fact, I would love to see the smart beta revolution yield the next wave of low-cost investment solutions firmly grounded in academic research and the investor-centric philosophy he championed. However, we’re a long ways off from there at the moment and I’m concerned. Let me explain.
It is no secret that investment management firms are profit-seeking organizations relentlessly competing for more assets. Even small investors who are unsure of the difference between active and passive managers know that both are trying to make a living. So, for the record, let’s say it loud and clear: Investment management is a for-profit enterprise. As such, asset managers and asset owners have a relationship beset with natural conflicts.
Asset owners want fees below 10 bps; asset managers prefer “2% + 20%.”1 Asset owners want transparency; asset managers favor black-box opacity. Asset owners want simplicity; asset managers hire rocket scientists to create complex optimized solutions for sex appeal.2 Asset owners want “future” outperformance after they fund a manager; asset managers would be satisfied with strong past outperformance to facilitate future asset gathering. Asset owners want a bigger alpha; asset managers would happily sell them the possibility of alpha and charge handsomely for the service of selling hope.
So, how does all of this relate to smart beta? Currently, asset managers are arguing heatedly about the right definition for smart beta. Some of our fellow investment managers secretly, and some publicly, hate the smart beta moniker. It’s not the “smart” that annoys them. We all think we are plenty smarter than the market. We simply wish it were called “smart alpha.” If normal alpha could fetch “two and twenty,” imagine what one could charge for smart alpha!
In fact, the debate about the right definition for smart beta reminds me of a parallel debate in risk parity. The absurdity of the fixation around definition is best captured by the following comment made by a senior investment consultant: “The conversation in the risk parity space is pure nonsense. Every quant manager argues that they have the most correct method for achieving risk parity in a portfolio. No one seems to address how achieving equal risk contribution for securities in an investment product is actually good for the end investor or why it is even relevant.” Isn’t it time to stop debating the definition of smart beta and focus on the most important question, “What’s in it for the end-investor when it comes to smart beta?”
The same core yet simple insight that motivated Jack Bogle to launch a capitalization-weighted index fund has the potential to be a transformational insight for smart beta as well—and that’s simply knowing the right question and having the courage to answer it. Given all we know about modern finance, what is best for investors?