ETF.com: What’s one of the biggest mistakes advisors and/or investors make when it comes to factor investing, especially if they're new at it?
Swedroe: The No. 1 mistake would be failing to have a strong belief system built from meeting all of those criteria I mentioned. You’re much more likely to stay the course through the inevitable long periods of underperformance every factor goes through.
Failing to understand that is a real problem, because what I've learned in my 20 years of experience as an advisor is that most investors, including institutional investors, think three years is a long time; five years is a really long time; and 10 years an eternity.
Financial economists know that when it comes to risky assets or factors, 10 years is nothing more than noise. That's the problem investors have: They fail to understand that, and abandon the factors.
ETF.com: Can investors do this by themselves, without an advisor?
Swedroe: It's certainly possible for an individual to do it, but—and I may be overstating it—probably a maximum 5% of individuals can really do it on their own. Warren Buffett has written for years what his strategy is. But very few people get Buffett-like results, because it isn't easy. Temperament matters more than intellect.
Advisors are likely to avoid behavioral errors because they're unemotional with other people's money. With your own money, you're much more likely to make mistakes simply because we're human beings and we are subject to emotions.
I think there’s a very small percentage of people who can really do it on their own. The vast majority would be better served by working with an advisor who will help them lay out the right plan.
Temperament matters most, but intellect is also crucial. You have to have a high level of mathematical understanding to figure out things like expected returns and how to run Monte Carlo simulations to figure out the right asset allocations to give you the best chance of achieving your goal. You need intellect in specific areas, and you need the temperament to stay the course.
ETF.com: One of your chapters is titled "The Truth About Smart Beta." What is the truth?
Swedroe: I don't want to say that there's no such thing as smart beta, but I believe the vast majority of things that are called smart beta are pure marketing gimmicks.
Let's see if I can separate what is smart beta from what is called smart beta.
First, let's define beta as a loading on a factor. And if it's just loading, there's nothing smart about it. It's just how much beta you have on the factor. If a fund construction rule gives you more loading on a factor so you own the bottom 30% of stocks by price/earnings ratio, then another fund that owns 20%, that's not smart beta; that's just getting more exposure to this factor. There's nothing smart about that construction. It's just getting more exposure.
Having said that, there are many ways a well-constructed, well-run mutual fund or ETF can add value, because there are some things that index funds do that are negative. All index funds, except the total market funds, are basically dumb indexes.
For example, take the Russell 2000 [index of the bottom 2,000 stocks in the Russell 3000 Index]. A stock that's ranked 1001 is in the Russell 2000, and a stock that's ranked 999 isn't. Every year the index reconstitutes. Imagine that a stock ranked 999 and 1001 swapped places.
Now, a Russell 2000 fund has to trade both, buying and selling, when both stocks are virtually identical from a risk and expected return perspective. They have the same loading on the factors that explain return.
So why do you want to trade? Especially when you know that the active managers know when you have to trade, and will front-run you and exploit you. That's just dumb. That's what index funds do. Their sole goal is to be a replicator and avoid tracking error. To me, that's dumb. I'm willing to accept what should be random tracking error if I can gain a higher expected return.