Tom Dorsey: 'Smart Beta' Is ETF Alchemy

Tom Dorsey, president of Dorsey, Wright & Associates, was doing his own version of smart-beta strategies decades before the term was even coined. His firm’s approach is entirely rules-based and built around the relative-strength concept, even when not encapsulated in an index. The methodology replaces human intuition with quantitative data. It underlies popular ETFs marketed by PowerShares and First Trust. But perhaps the largest endorsement came from the Nasdaq when it recently purchased the firm for $250 million.

How you would set the parameters of what is smart beta and what isn’t smart beta?
Well, here’s the thing with smart beta: To me, it’s a very smart marketing ploy. Somebody in marketing figured that out and said, “Hey, we’ll call this ‘smart beta.’ And then we’ll incite a riot and we’ll get everybody involved.” And the next thing you know, everyone’s doing what’s called smart beta.

In my opinion, that’s what it is. Because, really, what does “smart beta” mean? What’s the opposite of smart beta? Dumb beta. I don’t like to use that term either; let’s call it “inert beta.” That would be something like the Standard & Poor’s 500 cap-weighted. And that’s what every money manager pits themselves against. In 2014, 88% of managers failed to beat the S&P 500. And that’s cap-weighted. That doesn’t even bring in the smart beta equal-weight, which is a whole other story.

I would say the inert beta would be the indexes. If you want to just be an also-ran or you want to just be with the S&P 500, then just buy the S&P 500. And you can do that at extremely low, almost no cost whatsoever. You own all 500 stocks. And you are the market.

But what is that worth? It’s worth virtually nothing. It’s worth what Vanguard charges you, which is an almost nonexistent fee to own the S&P 500. So how does a person earn his keep? Well, now you have to figure a way to have to bring in maybe a little more volatility to this, or to bring in something that’s more unique and add it to that S&P 500 to be able to get some incremental return.

Our ETFs with First Trust involve, No. 1, a fundamentally based approach with the AlphaDex funds, and then you take our relative strength and put it on top of that. You end up with an almost unbeatable combination, but what you also have there is what I would call smart beta. To me, smart beta is ETF alchemy. And it’s a transmutation of common ETFs into an amalgamated investment solution.

How does your relative-strength approach fit into that?
If I take H₂ + O, and combine the two things, what do I get? Water. Let’s say I used ETF alchemy, and took the cap-weighted Standard & Poor’s 500 and I added to that the equal-weighted Standard & Poor’s 500 and then added to that a proxy for a cash position. If I compare the relative strength of the three of them together, it’s a big arm-wrestling contest of three people sitting down and arm wrestling each other to see which one is the strongest on a relative-strength basis, and 100% of the portfolio was going to whichever one was strongest. Now you have smart beta.

We put the three together and came up with a portfolio that I would say 99% of all money managers never outperform.

Why do you think it is that you never hear about the equal-weighted S&P 500 on TV anywhere? Always cap weight; you never hear about equal weight.

I don’t know, but I’ve wondered about it.
I’ll tell you why. Because the equal-weight index—the exact same 500 stocks reweighted—outperformed the cap-weighted hands down for the last 15 years easily. If you were in the equal weight and did absolutely nothing, you’d probably outperform 100% of the money managers out there. The ones that did not underperform were the ones who got really granular and owned biotechnology only, that kind of thing. The equal-weighted S&P 500 is a redheaded stepchild.

You’ve got to wonder what the SPIVA report would look like if it was using the S&P 500 equal-weight index as its benchmark.
It would be horrible! But then you would find that the academics would have all kinds of reasons why the exact same 500 stocks do better than the other ones, and why you can’t use that as a benchmark. Whatever you want to use as a benchmark, people want to get ahead. In my opinion, as far as financial planning is concerned, the best financial plan you can give anyone is a stock that goes up—plain and simple.

Do you consider relative strength to be a factor?
Factor is another one of those marketing words, and it’s mostly for reporters. Dividends are a factor. Relative strength is a factor. Whatever. It is what it is. When I think of smart beta, I think of rules-based.

Let’s say you’re an astrologer and you’re a money manager. And let’s say when Jupiter is aligned with Mars, you buy the Standard & Poor’s 500 equal weight. That’s smart beta right there. It’s rules-based. It happens to be astrology, but it’s a rule that you stick with. That’s the smart beta part of it.

There are so many different strategies out there. Are there any you feel are perhaps inappropriate or lead investors down the wrong path or to take risks they’re not really aware of?
Yes. I think the two times, three times leveraged ETFs really are designed for professionals and traders and might lead someone down the wrong path. But caveat emptor: If you’re going to invest in ETFs and you know nothing about it, get someone who does. If you do know a lot about it, then just be sure you understand what you’re getting into, how that portfolio is managed, look at the backtest on it, see how well it’s done overall in a lot of different types of markets.

Do you consider currency-hedged equity ETFs to be smart beta?
Yes. In my opinion, a currency-hedged ETF is smart beta; no question about it. Currency is extremely volatile. It makes a tremendous amount of sense to hedge the currency effect away. And investors like it. It certainly wouldn’t be called dumb beta. It wouldn’t be called inert beta. I’d say it’s smart beta.

Do you think what lies ahead for smart beta will eventually take the manager out of the way?
Will technology take money managers out? Ultimately. Maybe not in my lifetime, but it has to. Technology is not going to get worse. It’s going to get better. It’s going to get faster. It’s going to get smarter. Take the computer Watson. Watson is not going to sit around and just play “Jeopardy.” Watson is going to do all kinds of cool stuff.

And in the financial business, that’s next, because we deal with numbers. Don’t think Amazon.com isn’t going to come into the advisory business. Don’t think Facebook isn’t going to end up in the advisory business. Don’t think Google isn’t going to be in the advisory business—they already have Google Finance. So these things will get better and better and better.

John Bogle has said you can never underestimate consumer greed in that not everyone is going to settle for market returns. But will people be willing to settle for rules-based returns? When are they going to fall out of love with the idea of a human picking their stocks?

Well, they’re already falling out of love with it, because that’s what the robo advisors are doing. Wealthfront is gaining traction very fast. It will manage your port-folio exactly as an advisor on Wall Street for 25 basis points.

Vanguard will do the exact same thing, but it’ll give you a real person who is a certified financial planner plus its nonexistent-fee ETFs. It’ll do modern portfolio theory for you for 30 basis points. Charles Schwab just came out with the same thing, priced at zero. And Nasdaq just bought us for $250 million.

What’s the picture? What’s going on here? Nasdaq was buying a company that was one of the top firms in rules-based approaches. We’ve been doing it for 28 years. That shows you where the interest is going here: It’s toward that smart-beta side.