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The Case Against Smart Beta Funds?

| | Posted in: Big Ideas

Smart beta strategies weight stocks according to one or a few historically predictive factors such as value, size, momentum or volatility rather than market capitalization. What are the cautions for investing in smart beta funds? In their April 2015 paper entitled “Smart Beta: Too Good to be True?”, Bruce Jacobs and Kenneth Levy critique the belief that smart beta strategies beat the market simply and cheaply. Using selected observations and citing some past research, they conclude that:

  • Smart beta strategies are active in the sense that they require several performance-sensitive decisions regarding:
    • Which factor(s) to use.
    • How to measure the factor(s).
    • Whether to implement a tilted or a pure (e.g., top tenth) portfolio.
    • How frequently to rebalance/reform the portfolio.
  • An investor picking a smart beta fund or funds retains the burden of selecting which factors bets.
  • Smart beta factor bets may have ancillary sector biases/unintended risks. For example, a bet on high price momentum in 1999 (low volatility in 2009) overweights the technology (financial) sector just before a period of substantial underperformance.
  • Rigid factor bets, ignoring dynamic relationships between factor premiums and economic/market conditions, may have long periods of underperformance.
  • Portfolios tied to a handful of factors targeted by smart beta funds overlook opportunities associated with dozens or hundreds of other factor premiums.
  • The transparency of smart beta funds renders them vulnerable to front-running and crowding, both of which drive up prices of associated assets and lower their future returns.

In summary, smart beta strategies are not ingredients for a simple and easy recipe to increase returns while reducing risks.

Cautions regarding conclusions include:

  • The paper presents no evidence that alternative active management approaches outperform smart beta. The many-ignored-factors argument ignores the overlap/interference among factor portfolios and the costs and snooping risks of complexity.
  • The paper seems to have more points of argument than elements of evidence.

See also the closely related “Static Smart Beta vs. Many Dynamic Proprietary Factors”.

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