You always said, the cards would never do you wrong. The trick you said was never play the game too long - Bob Seger
Play not with dice: no, cultivate thy corn-land. Enjoy the gain, and deem that wealth sufficient. There are thy cattle there thy wife, O gambler. So this good Savitar himself hath told me. - RV 10.34, “Gambler’s Lament”
When I first heard of the phrase “smart beta”, I thought it to be more an alt-right neologism for verbal violence than an investment strategy. After some initial hesitation, I dived into it and found a bunch of slimy concepts thrown together and given a label that offends my testosterone at a molecular level, but since I am not my testosterone, I trudged on.
Here’s a list of what I found FT had to say about smart beta:
- No strict definition, elusive term
- Rules based investment strategies
- Criticised for delivering sub-optimal returns
- Alternative weighting schemes
- Based on measures such as volatility or dividends
- Designed to take advantage of perceived systematic biases or inefficiencies in the market
- Costs less than active management
- Fundamentally weighted indices
- Interest in smart beta fueled after GFC
- less expensive for investors to evaluate the worth of these strategies than to analyse and monitor the performance of active managers
- Returns from illiquid or private markets
Let’s leave the formalizing of a proper definition of “smart beta as an investment strategy” to the acedemics, I’m barely qualified to write even this, but what I can do is pick apart the concept and definition for you to stitch together, so here we go:
No strict definition: since when?
Elusive: maybe for some, but then, not all strategies are for everyone.
Criticised for delivering sub-optimal returns: as I said, the term seems to represent a lumpy synthesis of experiments that perhaps showed promise in the twinkle of some naive CTAs eyes, but failed to register with the market, or were given up on too soon. Criticising it would be the equivalent of putting all the shit students in the same class so the teacher can give them all ‘C’s. Besides, there are other trading issues discussed below.
Alternative weighting schemes: Ok, so smart beta strategies sit between active and passive ones as illustrated in the diagram below:
When you look at the venn above, you must think to yourself, that at least some of these strategies must be more active than others, however, you could be wrong. FTSE Russell has the anatomy of the smart beta all figured out. According to it, “a well-designed smart beta index should retain the key characteristics of a traditional index”. These charecteristics are:
- follow transparent, published rules
- be managed by an independent index provider
- clear governance procedures
- offer access to a broad range of markets and asset classes
This all seems fair, even if you want to capture “systematic bias” in the market, except that there is nothing about this anatomy that encourages an “active” management style. Might as well call this smart indexing (I’m sure that exists too).
FTSE Russell goes on to say, “In general terms, smart beta indexes depart from the standard methodology of weighting constituents by their market capitalization in order to reflect a variety of different objectives”, ok, so more indexing. I mean, how hard can it be to come up with new weights for an index this day and age? I’m sure that there are interesting and profitable ways to do this, but once done, how often do these weights get changed?
But alternative weightage is only one part of the binary as described to us by the experts, the other, are factor indexes.
- Based on measures such as volatility or dividends: the other kind of smart beta indices, or Factor indexes, capture the return of factors which have historically demonstrated excess market returns over the long run. This is perhaps the more active kind of smart beta, and probably where it gets the “smart” from but even this isn’t exactly “active”, and hovers in the centre-left of the venn’s naval.
Designed to take advantage of perceived systematic biases or inefficiencies in the market: it’s the word “systematic” that irks me here. We get too emotionally tied to the systems we create, we get hemmed in or crowded out by them. Systems are for people who identify with them. Not all fuzzy systems are systems in the strictest sense. Perhaps someone someday will make an “emergent systematic” factor index with meta-factors that control the weightage of actual factors, and tie it all up in a neat little C++ algorithm, now that would be a truly smart beta index! (has someone done this?).
Cost: I don’t know anything about this, always assume you’re paying too much. I don’t think I’m writing for the people who buy Blackrock ETFs (you can call a $2.5 trillion ETF anything, it doesn’t matter), I’m writing for trader Joe trying to get better returns and for him, I see smart beta as essentially an active play on high volatility. In troubled times you want affection more than sex, right? Name your price. But if I were to talk to a fund manager about smart beta, I’d probably say something about the blue ocean strategy, I think that’d make sense because I think that there are fresh ideas on the borders of active and passive investing that are undervalued.
Strategy prototyping: This is self-explanatory, the flexibility of smart beta essentially renders all investment activity as an exploration of a more certain reward, rather than a search for riskier assets. Essentially, a rule of thumb for defining what gets to be called a “smart beta” strategy should be, does it allow you to “hang on tightly, let go lightly”. While others have gone “all-in”, smart beta resists without struggling.
Returns from Illiquid/Private markets: But perhaps, the saving grace of smart beta is in it’s utility in specific markets like real estate and infrastructure. I know, these are the slowest moving beasts in the jungle but they’re HUGE! and offer great risk-return ratio. Because they are huge they are more amenable to factorisation, and because they are slow, they’re more predictable, less uncertain.
My initial hesitation to smart beta made me ask myself why the finance industry is so sexist that the word that describes our holy grail is also the word that describes the zenith of masculinity? I don’t know the answer, but I don’t get to hooked up on nomenclature, and ignore labels like the plague.
Come to think of it, nomenclature in technology is only slightly less offending, and then we wonder why girls aren’t joining STEM.