Outsmarted Russell And S&P Indexes Have Become Dinosaurs

by: Ronald Surz

Summary

The mighty S&P 500 and Russell 3000 indexes are fading away, replaced by two disruptive innovations.

Centric Core is the first disruptive innovation. Using market indexes as core in core-satellite portfolios is like adding water to a fine 50-year old Scotch, a big mistake.

Smart Beta is the second disruptive innovation. Capitalization-weighted indexes can be beaten by “smart factors” like smaller company value.

The gauntlet has been thrown on the gigantic S&P 500 and Russell 3000 indexes, and these leviathans are losing. Hooray for the little guy! The S&P and Russell indexes are used for two reasons:

  • In active management, to supplement active managers in core-satellite portfolios, and
  • In passive management, to buy the entire market.

There are smarter ways to do both, as discussed in the following.

Centric Core is a smarter core that creates smart alpha.

Centric Core is a new disruptive innovation that replaces the S&P and Russell indexes in core-satellite portfolios, providing higher returns and better diversification.

Core-satellite investing continues to be very popular, combining a passive core portfolio with active satellite managers. It's an active-passive approach. Core-satellite has been embraced as a way to diversify and lower costs, but the S&P 500 and Russell 3000 as core do neither. They result in an underweight to the middle of the market, so they don't diversify. And they undermine active manager decisions with deadweight stocks the active managers deem unworthy. This dilution comes at a cost that can easily exceed the "savings" attributed to a passive index, so costs are actually increased rather than decreased. Centric is the new core that really does improve diversification and performance.

Core-satellite investing began in the 1970s, motivated by ERISA's expanded definition of diversification to encompass the entire pension portfolio as opposed to each individual fund in the portfolio. The original purpose of the core portfolio was a completeness fund, rounding out a team of specialist active managers. In its simplest form, an active growth stock manager and an active value stock manager are rounded out by a passive core, but the common practice for this core has been wrong.

In practice, "core" has always been a total market index, namely the S&P 500 or the Russell 3000. This practice dilutes active satellite managers rather than completes them. The S&P 500 and Russell 3000 indexes are value and growth and core, all wrapped into one. Active managers are paid high fees to pick concentrated portfolios of 20 or 30 superior companies. Adding in a market index brings in hundreds (S&P) or thousands (Russell) of deadweight stocks that the active managers don't like. It's like adding water to a fine 50-year old Scotch, a foolish and expensive mistake.

A better choice for core is the stocks that are not in active manager mandates -- good companies that are not on active manager radar screens. Most active managers are either value or growth and they are scrutinized to stay within their proclaimed specialty. Some stocks are neither value nor growth -- they're the stuff in the middle between value and growth. There's a continuum in styles, running from deep value to aggressive growth, and along the way there's a collection of "fuzzy" stocks that don't qualify as value or growth. There are 45 such stocks in the large U.S. company space. These are well-known great companies that are generally not held by active investment managers.

Dr Frank Sortino uses an active-passive approach to portfolio construction, using passive to fill in parts of the market where he does not find skill. His optimizer always calls for Centric Core. This implies that there are no active managers who excel at managing the middle of the market, which is no surprise. Those skillful managers who call themselves "core" are actually blend managers, covering core and value and growth. To capitalize on active-manager skill while maintaining diversification, a Centric Core completes the manager line-up, with only a 20% allocation.

A picture will help clarify the difference between Centric Core and the Russell 3000. The following X-Y plot uses Style Scan to examine the holdings in the Russell 3000 index as of June, 2016. Every dot in the picture below is a stock in the index, and the size of the dot is proportionate to the allocation to that stock. As you can see, the index contains a lot of value stocks and a lot of growth stocks -- thousands of them. Active managers will generally choose just a few of those stocks, typically around 30 stocks. Consequently, the Russell 3000 index dilutes active manager decisions by superimposing thousands of companies the active managers don't want to hold. Active management decisions are undermined and diluted.

Click to enlarge

By contrast, the smarter-beta Centric Core index occupies only the center of style space, leaving value and growth selection decisions to the active managers. It's smarter beta because it generates smart alpha by getting out of the way of active managers, and by rounding them out (completing them). Click to enlarge

Fundamental indexing creates a smart beta version of a market

Fundamental indexing is the other disruptive innovation that has outsmarted the S&P and Russell indexes, driving them toward extinction. Fundamentally-weighted indexes were introduced by Robert Arnott in 2004. Arnott is founder and owner of Research Affiliates, the developer of the very first smart beta indexes called "RAFI" -- for Research Affiliates Fundamental Indexes. Fundamentally-weighted indexes have come to be known as smart beta indexes because they are professed to outperform the market, as represented by traditional capitalization-weighted indexes. Smart beta competes with the giants on owning the market, offering the potential for higher returns. Smart beta indexes have attracted $500 billion, or about half of the S&P500/Russell 3000 combined market value, but this war has just begun, as the controversy continues.

Fundamental (smart beta) weights typically tilt toward value and smaller companies relative to their cap-weighted counterpart, because this tilt has a history of performing better, so it may be smart. The future will tell us how smart this actually is. Fundamental indexes are created for broad markets, like the U.S. or Europe; they are total market indexes.

But the lemmings have once again demonstrated that their stampeding can turn a potentially smart buy into something pretty stupid. So says Rob Arnott et al in their February 16, 2016 explanation of How Can "Smart Beta" Go Horribly Wrong? 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.

Arnott is concerned that the newcomers to fundamental indexing are messing up a good idea, implementing factor exposures that won't add value.

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 loser's game that has been played for decades -- namely, 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&P 500 or Russell 3000 indexes, and deserves to be the next big deal, following in the footsteps of smart beta, but without the questionable promises.

Sometimes a good idea has its limitations. When it comes to betas, you need to choose the smartness of your beta carefully. Standard smart betas don't play well with active managers. New, improved smarter betas are much friendlier playmates. Or put another way, if your investments are entirely passive, smart beta indexes may be for you. But if you use active management, you need the smarter-beta Centric Core index.

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.