Is It Time for Smart Beta to Be Smart?

Arnott further explained that, “The same goes for small-cap, with the current pricing of the Russell 2000 the cheapest it’s ever been. When it’s been this cheap before, small-cap usually beats large-cap by 10% per annum or more.” Arnott concluded, “That said, I would not expect small-cap value outperformance to be the sum of these double-digit alphas. I’ll settle for 15% per annum excess return!”

In a paper recently released, Research Affiliates discusses:

• The parallels between the AI narrative driving the current market and the dot-com bubble of a quarter century ago and the important concerns it raises for investors.
• The key to navigating any market narrative is less about adopting a strategy and more about developing an investment philosophy.
• Market narratives fuel bubbles and crashes. Simplistic cap-weighted and naive-value approaches may not be the best ways to capture the opportunities or mitigate the asymmetric risks these narratives present.
• The Research Affiliates Fundamental Index (RAFl) weights companies based on their real economic impact, creating a balanced portfolio that avoids the extremes of its conventional value and capitalization-weighted counterparts.

Of course, there are big differences today versus the dot-com bubble. Back then, large-cap growth internet companies had huge losses and negative cash flow, while today they are generating large profits and huge cash flows. Today, AI is fueling profitable growth.

Arnott is a believer in AI, but states it’s reflected in the market valuations, meaning it’s already priced into the market. Small-cap and value stocks aren’t going away. And market disruptors can be disrupted themselves, says Arnott. He said reversion to the mean is reliable in the long run but not in the short run.

Arnott is not alone. Vanguard, noted for its cap-weighted indexes, recently forecasted 10-year annualized returns as follows:

U.S. Growth 0.6%
U.S. Value 5.2%
U.S. Large cap 3.5%
U.S. Small cap 5.2%

Vanguard also predicts 7.9% annualized growth for international stocks.

Is the tide turning?

The first quarter of the year hasn’t been kind to growth. Morningstar shows large-cap growth with a 6.6% decline versus a 5.0% gain for value. Small-cap continues to underperform large-cap.

ETF	Q1 2025 Return
Invesco RAFI US 1500 Small-Mid ETF PRFZ	-6.7%
Invesco RAFI US 1000 ETF PRF	1.3%
Vanguard Total Stock Market ETF VTI	-4.8%

While value is showing some signs of life, small- and midcap stocks continue to lag. One possible explanation is that companies are staying private longer. A Morningstar paper titled Unicorns and the Growth of Private Markets reports there are now more than 1,300 private companies globally with valuations greater than $1 billion. Their average valuation is about $4.6 billion.

SpaceX and OpenAI have valuations of $180 billion and $157 billion, respectively. Assuming they eventually go public, they will do so as large-cap companies. Had they gone public in their early stages, small-cap smart beta funds would have greatly benefited.

The theory is that the best small-cap companies will continue to have access to private equity, and small-cap public equity will miss out on the star performers. I ran this by Arnott, who replied that the same thing would happen to large-cap growth — to perhaps an even larger extent. I suspect SpaceX and OpenAI don’t want the regulatory burden and costs associated with being publicly held companies.

My View

In the end, I found myself mostly in agreement with Arnott’s philosophy. He and I both agree with William Sharpe’s Arithmetic of Active Management that money invested in low-cost total stock index funds must best the average dollar invested, and that this translates to a virtual certainty of beating most investors. We agreed that launching new funds with new factors based on backtesting is worthless at best. We also both agreed that a total stock index fund is better than a large-cap growth fund or even an S&P 500 index fund, and that costs and diversification matter.

Finally, we both believe that investing should be long term and that moving back and forth between smart beta and cap weighted based on past performance will likely lead to disappointing results.

For me, I’m sticking to cap-weighted index funds. A decade ago, I proudly referred to my cap-weighted total stock ETF as “dumb beta” and went on a Morningstar podcast discussing why I embrace dumb beta. For Arnott, it’s a “nonprice-weighted index strategy.” While I call that active, it’s certainly a viable low-cost option.

Although I used to say, “If you can’t be right, at least be consistent,” I’m rethinking my view that consistency in any viable strategy is even more important than getting it right in the first place.

Allan Roth is the founder of Wealth Logic, LLC, a Colorado-based fee-only registered investment advisory firm. He has been working in the investment world of corporate finance for over 25 years. Allan has served as corporate finance officer of two multibillion-dollar companies and has consulted with many others while at McKinsey & Company.

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