Capturing market mispricing

The so-called ’smart beta’ products try to replicate success

ou gotta give it to these old guys. As they get older, many of them find it futile trying to be polite, or politically correct, or even civil. They just end up saying things in the most direct manner to get to the point, and to hell with anyone who’s got a problem with it.

This was evident in a recent interview Institutional Investor magazine did with one of the pioneers of indexing (as it’s referred to in the US), Vanguard founder Jack Bogle:

“Active managers are losing market share. Is smart beta their attempt to turn ...”

“Smart beta is stupid; there is no such thing. It’s an idiotic phrase. Quoting Shakespeare, I guess: it’s a tale told by an idiot, full of sound and fury, signifying nothing. It’s just another way of saying, ‘I know I’m going to be above average.’ Active managers are just trying to come back and say there is a better way to index, when they know damn well there isn’t a better way.”

As you can see, the old bullet (Bogle is now banging on the door of 86) is direct. And blunt. Why, he didn’t even allow the reporter to finish her question before he let rip.

So in case you haven’t been keeping up to date with developments worldwide, here is a quick snapshot. The smart people we used to trust to invest our money back in the old days are having a hard time at the moment. Markets have become so efficient and asset managers so competitive that it has become almost impossible to outperform a benchmark, like a market index, on a regular basis.

Instead, folks have been using products that mirror these market indices to such a degree that last year more money flowed into passive products than they did into conventional unit trusts in the US.

But Bogle’s comments weren’t just aimed at active managers. They were also directed at the ETF or passive investing industry. In the clamour to move away from vanilla products that compete purely on price, they have ushered in the second generation of index products, called “smart beta”.

But I have to take issue here with Bogle. His phenomenally important and successful contribution to the world of finance (Vanguard now has over $3-trillion in assets) was, of course, an innovation itself. So to say it’s nonsense that markets cannot continue to innovate for the better is a little short-sighted, in my view. He is, of course, living proof that they can.

So what are these creatures? Smart beta is a way to capture mispricings in the market. Some of us will be familiar with the “value effect”, as popularised by Warren Buffett.

Investing in companies with low price-to-book or price-earnings ratios, over a long term, tends to outperform a market index. It’s an anomaly that any student of finance will tell you exists. The same applies to more recent discoveries, like portfolios formed on the so-called momentum or low volatility effect. So to put it simply, smart beta products try to distil the work of proven investment strategies into a system that can be repeated for as low a cost as possible.

Today, even in SA, we see many more of these products entering the market. S&P Dow Jones Indices has recently unveiled products that will be formed on momentum, low volatility and dividend aristocrats strategies. They should be treated with caution, but not shunned.

To say it’s nonsense that markets cannot continue to innovate for the better, is a little short-sighted

Veteran investor John Bogle believes that ‘smart beta is stupid; there is no such thing. It’s an idiotic phrase’.