We've Been Outsmarted By Smart Beta. Let's Try Smart Alpha Instead

by: Ronald Surz

Summary

The founder of smart beta, Rob Arnott, says that it is likely to stop working, and he explains why.

Researchers continue to discredit smart beta, even though assets have grown to exceed $500 billion, which is about 20% of US exchange-traded assets.

It’s time to refocus on smart alpha instead of smart beta.

You can fool all of the people some of the time; you can fool some of the people all of the time, but you can't fool all the people all the time. -- P T Barnum (also attributed to Abraham Lincoln)

Lured by the prospect of outperforming the markets (as measured by capitalization-weighted indexes), investors have flocked to so-called smart beta indexes, driving them to exceed $500 billion, which is about 20% of all US exchange-traded product. Fueling this fire, Franklin Templeton recently joined the likes of Fidelity, Goldman and John Hancock in launching smart beta ETFs.

But the lemmings have once again demonstrated that their stampeding can turn a potentially smart buy into something really stupid. So says Rob Arnott et al. in their February 16, 2016 explanation of How Can "Smart Beta" Go Horribly Wrong? Arnott is founder and owner of Research Affiliates, the developer of the very first smart beta indexes called "RAFI," for Research Affiliates Fundamental Indexes. Here's what they say:

"We foresee the reasonable probability of a smart beta crash as a consequence of the soaring popularity of factor-tilt strategies.

"Performance chasing, the root cause of many investors' travails, has three inextricably linked components. Rising valuation levels of a stock, sector, asset class, or strategy inflate past performance and create an illusion of superiority. At the same time, rising valuations reduce the future return prospects of that stock, sector, asset class, or strategy, even if the new valuation levels hold. Finally, the higher valuations create an added risk of mean reversion to historical valuation norms.

"Is the financial engineering community at risk of encouraging performance chasing, under the rubric of smart beta? If so, then smart beta is, well, not very smart."

Add this to the preponderance of studies that refute the claims of smart beta and you see that investors have been outsmarted by smart beta.

Time to redirect focus to Smart Alpha

Smart beta is just the latest example of investor appetite for "Brainless Alpha." Investors want to beat the markets without thinking, but it's just not that simple. The only "magic" that has a real chance at delivering superior performance is good old-fashioned human intellect. Yes, I know that most active managers fail to beat their benchmarks, but this can and should change if advisors step up their due diligence by using Success Scores, rather than playing the losers game that has been played for decades -- the game of choosing the least bad losers.

With truly successful managers on board, there is a type of smart beta that enhances the delivery of human skill, i.e. alpha. This beta delivers smart alpha by getting out of the way of active managers while at the same time rounding them out into a well-diversified portfolio.

Centric core is a far better core than the S&P500 or Russell 3000 indexes, and deserves to be the next big deal, following in the footsteps of smart beta, but without the false promises. The tradition of using market indexes as core is like adding water to a fine 50-year-old Scotch; it's a big waste. Centric core is the 45 stocks in the middle between value and growth that active managers tend not to hold. They are good companies that have fallen off the radar screens.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.