No Correct Way
It’s important to understand that having more exposure to factors than the market does isn’t, in and of itself, either good or bad. There’s no one “right” portfolio. You should decide for yourself what the right portfolio is for your unique financial situation. And it should be based on your unique ability, willingness and need to take risk.
My book, “The Only Guide You’ll Ever Need for the Right Financial Plan,” can help you determine the right portfolio for your situation.
Don’t Throw The Baby Out With The Bathwater
Despite having spent so much time exposing much of what is called “smart beta” as a marketing gimmick, I should add that you shouldn’t totally dismiss the idea of smart beta out of hand.
The reason is that, while multifactor models do a much better job of explaining returns than the original CAPM, there still remain anomalies that the models cannot explain. Among those anomalies is that any asset with a lotterylike distribution has been shown to have poor risk/return characteristics. Exposure to these assets results in negative alphas (below-benchmark returns).
So, let’s look at an example of “smart beta.”
An Example To Consider
To begin, there can be many portfolios that have the same exposure to beta. Let’s assume that we start with a mutual fund (fund A) that that owns the total U.S. market. By definition, it will have a beta of 1.
Along comes a manager of fund B who says we can create smarter beta by screening out all the stocks that have been shown to have these lotterylike distributions. Those include shares of initial public offerings, “penny stocks,” stocks in bankruptcy and extreme small growth stocks.
Fund B will also likely have a beta of 1, but it can be expected to produce a higher return in the long term. Since the betas are the same, it seems perfectly appropriate to say that is smarter, or better, beta. Or you could say it’s alpha. The difference is just semantics.
It’s also important to understand that while index funds are excellent investment vehicles, their very nature tends to create some negatives. However, these negatives can be minimized and there are opportunities to enhance their positives. If you’re interested, you can read an article I wrote for Advisor Perspectives titled “Structured Portfolios: Solving the Problems with Indexing.” It covers nine areas of opportunity to add value.
The evidence demonstrates that incorporating the findings from academic research can result in the design of portfolios that produce returns superior to total-market portfolios and pure index funds. But be confident that the academic findings are reliable.
There should be a logical explanation (either risk-based or behavioral) for the findings. In addition, the findings should remain persistent over long periods of time and across asset classes and markets. And they should also survive transactions costs.
Whether you call the results “smart beta” or alpha, the outcome is the same—superior risk-adjusted returns.
Larry Swedroe is the director of research for the BAM Alliance, a community of more than 150 independent registered investment advisors throughout the country.