'Dumb Beta' Makes A Comeback

Rob Arnott’s firm, Research Affiliates, was one of the pioneers of “smart beta”—making use of his indexes that are based on weighting that employ fundamental characteristics rather than market-capitalization weighting.

Funds based on his fundamental indexes have taken in assets at a much greater rate (in percentage terms) than market-cap-weighted funds, which is sometimes referred to as “dumb beta.”

While the “RAFI indexes” have soundly bested most market-cap-weighted indexes over several years, according to Research Affiliates, the firm that licenses the indexes, the last 12 months have shown lags in nearly every category.

Compounding Differences

For example, for the 12 months ending Jan. 31, 2015, the FTSE RAFI All World 3000 lagged the MSCI All Country World Index by 2.18 percent, and the RAFI 1000 lagged the Russell 1000 by 0.61 percent. Throw in the higher costs and tax inefficiencies in smart-beta investing and the differences are even greater.

Is this an aberration? Probably, but no one knows for sure. The great debate is whether RAFI indexes eliminate a 2 percent annual drag on return versus market-capitalization-weighted indexes, or if they are merely an efficient way to harness value and smaller capitalization factors.

The former would imply free excess return, while the latter would imply compensation for taking on more factor risk. I happen to fall into the latter camp, though I think smart beta is a brilliant marketing move.

To my knowledge, neither Rob Arnott nor Research Affiliates ever implied that RAFI indexes would best market-cap indexes every year. In my opinion, the fact that smart-beta-based products are hot is cause for concern. Money flowing into stocks with these factors drives up the prices and could lower future returns. 

When money follows the herd, things often don’t end well, and this could be true with even a very sound and efficient form of active investing.