Cap­tur­ing mar­ket mis­pric­ing

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

Financial Mail - Investors Monthly - - Analysis: Exchange-traded Funds -

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’.

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