Ferri: Smart Beta And Tourist Investors

'Smart beta' is misleading marketing hype, Rick Ferri says.

Wall Street is always coming up with cunning new marketing techniques to attract tourist investors. These are less-sophisticated individual investors and advisors who are easily wowed by glitzy industry trends, only to abandon them when the strategy falls short of expectations.

The latest spin to attract tourist money is “smart beta.” The phrase didn’t exist one year ago, yet a Google search today shows 190,000 results. The inference that investing this way is smart has ignited a strong interest among less-sophisticated investors, while those who truly understand what’s behind these strategies find the phrase distasteful at best.

Beta was introduced into finance literature by Nobel Laureate William Sharpe back in the 1960s. The term denotes the risk of the stock market and it is always stated numerically at 1.0. Beta is used in portfolio management to quantify a stock portfolio’s sensitivity to market risk higher or lower than the market beta. A portfolio beta greater than 1.0 means the basket of stocks had higher risk than the market. A beta less than 1.0 means the portfolio had less market risk.

Since the introduction of market beta, cheaper computing power has made quantitative analysis of the stock market much faster and less costly. It was discovered that other broad risk factors exist in the market besides market beta, and these too have been quantified. When these risk factors are intentionally overweighted in a portfolio, it has historically outperformed the market, albeit with more total risk than the market.

These additional risks can be expressed in many ways. Some academics call them factors, and other academics call them additional betas. Some people in the industry call them alternative betas, which is not a correct term. Two of the most popular factors used in portfolio construction are the small-cap risk factor and the value-stock risk factor.

Smaller companies tend to outperform larger companies over time. This is due to additional concentrated risks such as a narrow industry focus, less distribution, higher cost of capital, less liquidity in the stock, etc. These risks are quantified and expressed as one number (or beta) and referred to in the industry as the small-cap effect.

The value-stock factor is the tendency of value stocks to outperform growth stocks over the long term. Value is differentiated from growth by sorting accounting data such as dividend yield, earnings yield and return on equity. Companies with these fundamentals tend to outperform stocks that do not have the same fundamentals. These risks can be quantified and expressed as one number (or beta), and are often referred to in the industry as the value effect.

The quantification of small-cap and value betas within the stock market goes back several decades. The value effect was first quantified in the late 1970s, and the small-cap effect was documented in the early 1980s. These two factors were combined with market beta in 1994 when Nobel Laureate Eugene Fama and Kenneth French formulated the Fama-French Three Factor Model. Their eloquent model is widely used in portfolio management to quantify the three distinct risks in stock portfolios.

With the Fama-French model in hand, portfolio managers began engineering baskets of stocks that held controlled allocations to market beta, small-cap exposure and value-stock exposure. A portfolio designed around a multifactor risk profile has traditionally been called multifactor investing.

During the 1990s, Dimensional Fund Advisors (DFA) was the first investment company to engineer multifactor mutual funds based on Fama-French research. They spent many years educating advisors on how the model worked, and their efforts have paid off handsomely. To date, DFA manages more than $250 billion for investors using multifactor strategies.

It took the rest of Wall Street nearly 20 years to figure out how to explain multifactor investing to less-sophisticated investors. Selling directly to the public was different than the educational approach DFA took with advisors. Wall Street's answer was to rename multifactor investing as something trendy and sophisticated sounding, and that inferred higher profits with less risk. It named it “smart beta.”

I would venture to guess that only a small percentage of investors who own mutual funds and exchange-traded funds (ETFs) that are marketed as “smart beta” would be able to accurately define what market beta is. Ask them to define beta in terms of a small-cap or value effect and you’ll likely get a blank stare. Mention other risk factors such as low volatility and you’ll send people into a tizzy. This makes “smart beta” an ideal marketing spin for Wall Street.

A recent advertising campaign by Research Affiliates highlights how this spin works. The company defines “smart beta” on its website and in print ads as: 1) investable indices built for outperformance; 2) rules-based, transparent, broad market exposure; 3) low-cost investments offering the best of passive and active.

It sounds very enticing, but what’s missing? Notice the word “risk” isn’t mentioned once. The ad instead focuses on beating the market, rules-based methods and lower cost. This creates the illusion that “smart beta” leads to increased return without an increase in risk.

It should be understood by everyone who buys into a “smart beta” strategy that success may not occur for a very long time, if at all. In January 1984, if you had invested $1 in the Russell 3000 broad market index and another $1 in a portfolio that held 70 percent in the Russell 3000 index and 30 percent in the Russell 2000 Value Index, it would have taken the multifactor mixed portfolio almost 17 years before it outperformed the broad-based Russell 3000 index. The figure below illustrates these results.

Total Return Of Russell Indexes Rebalanced Annually

Source: Russell Investments, 70/30 index calculated by Rick Ferri

In a more vivid example, small-cap investing itself has underperformed large-cap investing since Rolf W. Banz quantified the concept and published his findings during 1981 in the Journal of Financial Economics. Since January 1982, the Russell 2000 small-cap index has underperformed the Russell 1000 large-cap index by 0.9 percent annually while taking 4.0 percent more risk as measured by annual standard deviation.

Nothing fails like success on Wall Street. Typically, those who are first to a strategy are the beneficiaries. The benefits quickly diminish by the time the mass market arrives through commoditized products such as those recently introduced under the “smart beta” banner.

I find it humorous that the industry is once again attempting to convince us that everyone can be above average. We know that’s not true. There is only a limited supply of “smart” investments out there, and by the time a product is sold to the mass market under a “smart” title, it’s usually a day late and a dollar short.

In summary, multifactor investing involves three challenges going forward: 1) any excess earned by investors must first overcome the extra cost of the strategy; 2) greater mass-market participation in a strategy typically means lower expected premiums for all; and 3) risk premiums are not guaranteed—it could take more than a lifetime or longer to see a benefit.

Multifactor investing isn’t for tourist investors. The strategy requires die-hard discipline, which means a complete understanding of all risks. Anything less leads to jumping ship at the wrong time, which locks in underperformance and guarantees failure.

I don’t want to give the impression that I’m against multifactor investing in portfolios, because I’m not. I honestly don’t know if taking multiple risks in a portfolio will pay off in the future as it has in the past. In an efficient market, the more risk you take, the higher your expected return. So, there is a probability that this strategy will generate better-than-market results, but I can’t say what that probability is or how much the excess return might be.

The default option is to stick with a portfolio composed of total market index funds. These core products are extremely low cost and easy to maintain. It’s a strategy that I like, and Warren Buffett does also. As Buffett says, “I’d rather be certain of a good return than hopeful of a great one.

This blog, which first appeared on Rick Ferri’s blog, is part of a regular series of articles on IndexUniverse featuring some of the most influential voices in the world of index and passive investment. Ferri is the founder of Portfolio Solutions, a Michigan-based registered investment advisor with about $1.2 billion in assets under management.