Bill Sharpe: "Smart beta makes me sick"
Sharpe used a similar line of reasoning to explain why a static 60/40 asset allocation cannot work for all investors. If a particular strategy is good for some investors, then it can only work in the long run if markets can “clear,” he said. That means that the strategy must continue to offer its benefits regardless of how many investors pursue it.
Consider an average investor or institution who wants to take as much risk as possible and get the same expected return as the overall market. If the capitalizations of the stock and bond markets are in a 60/40 proportion, then all investors can have this allocation.
Imagine, Sharpe said, what would happen if stock prices rose relative to bonds, and the market was weighted 70/30. Now, to have a market portfolio, you should be 70/30.
But virtually all investment policy statements are written with static allocations, such as 60/40. In that case, to rebalance, investors must sell winners (stocks) and buy losers (bonds).
Here’s the problem: Not everyone can do that, at least at then-current market prices. Markets would not allow all investors to revert to a 60/40 portfolio.
Adaptive asset allocation solves this problem by replacing a static asset allocation (e.g., 60/40) with a dynamic one that allows investors to be 70/30 when the market is weighted that way. Sharpe also said he derived a formula that determinates how to allocate your portfolio if you want to be riskier or less risky than the market.
Returning to the topic of smart beta, Sharpe acknowledged that index funds have their limits too. “We absolutely need people who are looking for mispriced securities,” he said. If all investors held index funds, then the shares of those funds would be bid up. Active management provides a social service, he said, that benefits index investors.
He said he used to worry about too much indexing. “But human nature is such that people will continue to look for under- and overpriced stocks,” he said. “I stopped worrying.”