Smart Beta Wins The War; Holdouts Persist

Smart Beta Wins The War; Holdouts Persist

You may not like the term ‘smart beta,’ but what's behind the name is what really matters.

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Reviewed by: Edgar Senior
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Edited by: Edgar Senior

[Editor's note: An earlier version misidentified Fischer Black as a Nobel Laureate, when it should have stated William Sharpe.]

When BlackRock finally stopped using the competing phrase "strategic beta" in 2015, I hoped that the "smart beta" terminology wars had come to an end. But just like Hiroo Onoda, the lone Japanese soldier from World War II who was found isolated on a Pacific island three decades later, still fighting a conflict he hadn't realized was over, a few holdouts are stubbornly persisting.

And what a confusing war it was! The following table lists just 12 of the many synonyms I've come across:

Some Past Synonyms For Smart Beta

It was only in September 2014 that a piece from BlackRock in Institutional Investor had argued that "The term 'strategic beta' better describes the products and strategies we've developed that seek to deliver exposure to the factors that are long-term drivers of asset class returns," but by January 2015, it published a paper titled, "Smart Beta: Defining the Opportunity and Solutions."

Deutsche Asset Management also recently waved the white flag of surrender, moving on from the "systematic beta" it advocated in an article in March 2015 to embracing the phrase "smart beta" in its May 2016 Monthly ETF Market Review (although their website's drop-down menus still refer to "strategic beta," so perhaps they are hedging themselves).

Similarly, I like to take some small credit for encouraging Source, Europe's largest independent ETF issuer, to switch from its vague "beta plus" to "smart beta" in early 2015. The websites of Lyxor and Amundi, two of Europe's largest ETF issuers, have also recently started to refer only to smart beta.

And it's no surprise that more and more market participants are settling on smart beta as their preferred term, as it's been consistently in use since 2000 or so, when Towers Watson is widely acknowledged as being the first to popularize it (although it defined it much more broadly than we think of it today—essentially everything that was neither "bulk beta" nor actively managed; thus, even including thematic indexes).

Research Affiliates has also long used smart beta for its suite of fundamental indexes, which launched in 2005 and powered the very first smart-beta ETFs. Now with over a 10-year live track record, and in excess of $100 billion of assets linked to its smart-beta indexes, it has some authority on the matter.

 

The Original Advocates, Converts And Holdouts

An Unloved But Accepted Term

Amusingly, even its harshest critics agree it should be called smart beta. Nobel prize-winning academic William Sharpe has been quoted as saying, "When I hear 'smart beta,' it makes me sick." In January 2015, Jack Bogle, founder of Vanguard and father of index investing, told Institutional Investor, "Smart beta is stupid."

And the latest edition of the million-selling "A Random Walk Down Wall Street" by Burton Malkiel (which I can't recommend highly enough) has a chapter called, "Is Smart Beta Really Smart?" I don't have to tell you what this great defender of efficient markets concludes.

Despite this clear victory for smart beta, I should add that very few of its proponents actually like the phrase. AQR put it perfectly, in a paper in September 2014 titled, "Smart beta, not new, not beta, still awesome," where the first footnote specified, "Note that while we've been critical of the term 'smart beta' in other articles, here we just fully accept it. Even if it's not the term we'd have chosen, it is being so widely used, we concede. Language is, after all, a democratic process!"

I couldn't agree more—I wouldn't have chosen the term either, if starting from a blank piece of paper. But language rarely evolves in a sensible, organized fashion. In truth, I don't like both halves of the phrase: "Smart" is pure marketing hyperbole, promises far too much from what can be very simple products, and falsely suggests that passive investing is "dumb." Meanwhile, the word "beta" is downright confusing for products that often seek to outperform the traditional beta of the market. Other than the "smart" bit and the "beta" bit, I love it.

However, as ugly as it is, most of the remaining alternatives aren't much better.

 

No Better Term

The phrase "alternative beta" is one of the synonyms still occasionally rolled out, but the minor objection is that it's taken! This exact term has been in use for more than a decade to mean the betas (as in passive, marketwide, representative benchmarks) of "alternative" asset classes, i.e., alternatives to the traditional asset classes of long-only equities and fixed income.

Thus, commodity indexes, or timberland, or even hedge fund replication indexes, have all been referred to for many years as "alternative betas," so to extend the same terminology to a long-only portfolio of equities selected based on dividend yield is simply a misleading use of "alternative."

Similarly, Morningstar is a firm advocate of "strategic beta," correctly pointing out that the word "smart" has no serious place in finance. They're not wrong, but nor is the word "strategic" any more accurate. Why is an index that screens the U.S. stock market for size, liquidity and free float not "strategic," but if I add a filter for dividend yield, it becomes so? 

I also quibble with Morningstar's underlying definition, which is far too broad, including complex systematic strategies (such as Source's Man GLG broker capture strategy) that no investor would view as smart beta.

And that brings us to the real point here: All this debate about terminology is distracting the industry from the far more substantive discussion, which should be about how investors can use smart beta to achieve their goals.

So please, let's all stop proposing competing names (even if they are better), let's all stop advocating self-serving definitions that happen to suit our own product ranges (which is still far too common), and let's focus on educating investors about how to get the most out of smart beta.

Oh, and for those last few soldiers bravely and stubbornly defending their islands, let me finish with an inconvenient fact. Guess what Investopedia's most-looked-up term was in 2015?

 

Edgar Senior is the former head of product development at Source. Previously, he ran Goldman Sachs' fund-linked structuring and marketing in Europe. Senior is currently pretending to be doing "freelance consulting."