Given the history of miracle cures, magic potions, sure things, and can’t misses, you will forgive our skepticism as “Smart Beta” entered the financial lexicon over the past 3 years. Things promising to be “smart” often look very dumb in retrospect. But we were intrigued, if only because humility and competition demand an open mind.
For those unfamiliar with it, the concept behind Smart Beta is to take a market capitalization-weighted passive index, such as the S&P 500 or the Russell 2000, and make it “smart” by screening for stocks with a desirable characteristic, such as low volatility, or high momentum, or less leveraged, or low Price-to-Book, etc. The stocks which pass the screen, which can vary in number from 100 to upwards of 1000, are then purchased in equal amounts for the fund, with the screen being re-run and the portfolio adjusted on a monthly, quarterly, or yearly basis.
It is probably no accident that Ben Graham did not name his most popular book The Smart Investor, instead choosing the more measured “intelligent” to describe the human ideal to which we should aspire as investors: to consistently use our cognitive skills and real world experience to achieve satisfactory returns over the long run. Indeed, throughout The Intelligent Investor, Graham generally uses the terms “smart” and “smart investors” in the context of giving examples of failed investments and speculators getting their “come-uppance.”
It is argued by proponents of Smart Beta that this allows investors to take advantage of “anomalies” in stock markets wherein cheaper, higher quality, lower volatility, etc. companies outperform over certain periods and in certain conditions. Twenty years ago this was known as “factor indexing,” though the means for accomplishing it were much more limited in the pre-ETF era. To our mind this also looks suspiciously like the portfolios created by the asset management firm LSV Asset Management, which has been running its 500-1000 stock “value equity” portfolios by solely screening for low price-to-book and other indicia of value since their inception in 1994.
The only two aspects of Smart Beta which are truly “new” are the term itself and the use of a low-cost ETF vehicle to deliver it. Those advocating Smart Beta assert that the decisions to overweight and/or underweight particular characteristics in their funds are not active investing, but merely “less passive” than the pure market cap weighted index funds in days of yore. Some go so far as to drive their point home by trademarking their products as “Passive Smart Beta”. While we applaud the potential for lower cost delivery of investment services to the public, we disagree with the characterization of Smart Beta as a passive strategy because we believe it to be materially misleading.
Perhaps we are blinded by our own adherence to a very active form of investing and we cannot therefore grasp why advocates of Smart Beta should be so adamant about its classification as a passive form of investing. In Ben Graham’s day, what we call “passive,” he and others called “defensive” and cast no aspersions upon it in the least. Indeed, we can think of almost no active equity manager, Value, Growth, Momentum, Long/Short, and all stops in between, who does not begin their process by screening. Yet, for the most part, sales and academic literature on the topic of Smart Beta go to great lengths to highlight the passive aspects of this method, while downplaying the very active aspect of weeding out undesirable companies
Why should this be so? Perhaps it stems from the fact that passive fund firms such as Vanguard or Invesco have been hammering active managers for the past several decades for periods of underperformance versus the “unmanaged” indices. It is not as though “dumb” Beta market cap weighted indices were not themselves tainted with the possibility of human folly: their criteria, categories, and constituents are vetted and chosen by humans as well. There are subjective judgments that must be made in the construction of even the most passive of indices. They are not ordained nor is their construction a law of nature: some human, somewhere, is actively making a decision about index criteria.
In addition, tilting the construction of indices towards the performance “anomalies” that fly in the face of the Efficient Markets Hypothesis (“you can’t outsmart the market, so give up”) is an admission that the markets might not be so efficient after all. This should be obvious since markets are nothing but people, and, as amply displayed on modern “reality” TV, people may be highly irrational and serial utility minimizers. So why should the collective be any “smarter” than its constituent parts?
Admitting that Smart Beta is either “passively active” or “actively passive” would seem the more candid route for this investing methodology. Just as it is hard to be a “little bit pregnant,” it is also hard to be a “little bit active” if the purpose of the exercise is to produce performance different enough (presumably better) than the more purely passive index fund alternative.
We are not alone in our skepticism over Smart Beta: none other than the Father of Beta and the Capital Asset Pricing Model, holder of a Nobel Prize for his creation, Bill Sharpe declared that “Smart Beta makes me sick” at a May 5 CFA Conference in Seattle. Whereas the whole concept of market efficiency and its offspring, Beta, make us queasy, what apparently nauseates Sharpe is the idea that Smart Beta will only stay smart as long as the mass of investors do not adopt it.
If we understand Sharpe correctly, it might be more accurate to call this investment approach “Temporarily Smart Beta” since once enough investors crowd into a particular flavor of Smart Beta products, prices for those flavors of stocks will become fairly priced and the “anomaly” will disappear.
We think this is a fair criticism, as it is obvious that stocks, industries, and sectors do come into and out of favor. The extra twist of irony regarding Sharpe’s view on Smart Beta is that over the past 8 years, numerous Smart Beta ETFs have won the William F. Sharpe Award for Indexing Achievement from The Journal of Indexing and the Information Management Network.
Even MSCI admits that they “haven’t come across anyone who likes the term ‘smart beta,’ and this unfortunate phrase is clouding the discussion” as well as creating “a lot of noise on this topic which is not constructive,” according to MSCI Managing Director and Head of Index Business, Baer Pettit in a June PI Online supplement.
But we at Neosho can’t be too critical of Smart Beta, screening for liquidity, returns, lack of leverage, and arguably value pricing is Step One of our own portfolio construction process. The presence of some portion of all these four criteria is needed to form the basis for an intelligent investment decision, based on our study of the history of markets and economies, as well as a few decades of practical experience, provide the basis for an intelligent investment, but they alone do not tell the entire story.
Yet, there are more subtle factors at play in the longer term prospects of a company which do not reveal themselves in simple quantitative screening. Regulation, opaque accounting methods, management motivation, the pace of change, geo-political issues, competitive dynamics within an industry, national monetary and trade policies, and commodity cycles are but a few of the factors which do not easily lend themselves to simple numeric cut-off points. And so it is at that point that we move on to Step Two of our process and attempt to apply our intelligence and experience to cull our list further, often to zero, in pursuit of a higher probability of satisfactory returns.
Besides the fact that raw screens may flag many false positives, it should go without saying that while history may give us clues as to the future, it is not the future itself and that Joseph Schumpeter’s theory of capitalism as “creative destruction” holds true more often than not and that, to quote the great man himself, “[T]he process of industrial mutation … incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one."
Or, more simply, things change and last year’s or last decade’s success does not make next year a certain thing. Therefore, screening and selecting solely on the basis of historic data will miss trends obvious to the human eye, such as the demise of the IBM Selectric Typewriter or the Sony Walkman.
Therefore, while we are fans of both being selective about stocks and low fees, as exclusively active managers we do not believe that Smart Beta will consistently live up to the promise in its name thanks to market cycles and inherent flaws with mechanical formulations which eschew tinkering by mere mortals. No investing strategy can be “smart” in all environments, or through all circumstances, whether active or passive in nature. We may not always be smart, but we can always strive to be intelligent.