SmartBeta offers compromise
• Factor-based investing attractive to investors aiming to combine active and passive approach
When investors look at the pros and cons of active and passive investing, SmartBeta looks like a convenient halfway house. The marketer who dreamt up the name “SmartBeta” deserves a lot of credit — they were previously known as the staggeringly dreary “factor-based investing”. This involves modifying an index based on specific rules.
The simplest form of SmartBeta is an equally weighted top 40 index. In this product each of the 40 shares would make up 2.5% of the index, whether Naspers and Richemont at the large end or Brait and Sappi at the tail. Satrix and Core Shares offer exchange-traded funds (ETFs) built on this basis. The best-known SmartBeta is Rafi, the Research Affiliates fundamental index, which is made of four different factors such as size, value and profitability. The father of Rafi is Research Affiliates boss Rob Arnott, who is to fundamental indexing what Colonel Sanders is to KFC.
SmartBeta products that screen for low-volatility shares as well as those targeting momentum strategies have proved popular. Investment techniques that focus on these factors have enjoyed the endorsement of such folk heroes of the chartered financial analyst (CFA) charterholder community as Eugene Fama and Kenneth French.
So, as they say, what’s not to like? Vanguard, the mammoth US manager known primarily as an index house, does not like this bastardised version of index funds. For a purist an index can only be a market-cap weighted index. Founder John Bogle argues it is in the public interest if index products are packaged in mutual funds, and not as ETFs, which are designed for traders not long-term investors.
Bogle is no longer a young man, so he has got Josh Barrickman to fight on his behalf against SmartBeta. Barrickman is head of bond indexing at Vanguard Income Group.
He compares investing to a motor race. An indexer tries to replicate the market car to ensure it ends in a dead heat. Active managers try to tweak their cars to beat the market (though with a far greater failure rate than Formula One teams).
How is SmartBeta participating in this race? It obviously is not trying for a dead heat. He says it is an active car without a driver. And he is not trying to make a flattering comment about Elon Musk and driverless cars — he means it is a dead loss. Barrickman argues that SmartBeta is not Beta (defined as matching the index) and fundamental indexing is not indexing.
I am not sure why he has singled out the Colonel Sanders of SmartBeta, but then Arnott has done a superb job of making SmartBeta and fundamental indexing interchangeable terms. Barrickman concedes SmartBeta is not bad for your health or wealth but it is not indexing.
In my view, there is a continuum from fundamental active, which I like to think of as the way an arts graduate or a lawyer would run a fund. A university friend of mine, Rory Powe, who had studied mediaeval history, ran a very successful European equity fund for Invesco in the 1990s. Since then, funds have been usually run more heavily around the numbers, and less on, say, the CE’s personality. But they still employ a good chunk of subjectivity.
Next along the continuum are the quants funds, which employ mathematical filters to run their portfolios — but somebody still has to choose the right filters.
So the line between quants and SmartBeta is wafer thin. The main difference is that SmartBeta is far more transparent; quants is the version of SmartBeta you find on the DarkNet.
I agree with Barrickman that indexing by definition is owning the market and fundamental indexing is betting against the market. It belongs in the active bucket. But as Vanguard puts it — and surely the great John Bogle agrees with every word Barrickman says — the SmartBeta promoters have every interest in fudging the issue. Why not benefit from the popularity of index funds by focusing on the similarities and not the differences? And compare the systematic approach of SmartBeta to the increasingly ineffective gut-feel approach of active managers.
In SA, SmartBeta is the only kind of active management approach that is permitted in ETFs. And particularly in the US, the incumbents in traditional index funds such as Vanguard and BlackRock/iShares, have a huge advantage over young pretenders. Their scale allows them to charge as little as eight basis points (0.08%) on a standard S&P 500 tracker. In the less cutand-dried world of SmartBeta small businesses can still make money if they have a clever enough marketing message.
Barrickman confronts an issue that has troubled me in the past — the role of a market-cap weighted global bond index. In equity funds, in theory the highmarket-cap companies should be better managed and have larger assets. But in a bond fund the high-market-cap securities and countries are those with higher debt levels. But he says there is no evidence that adding filters around, say, leverage or interest coverage would benefit returns. Changes in bond prices are not directly related to an issuer’s creditworthiness.
Vanguard argues that SmartBeta might even be seen as the worst of both worlds. It is an active strategy locked into a certain style without the ability to toggle between risk factors.
The skill talented active managers offer in terms of trading strategies and specific positions is not there. It is ironic that Vanguard brings that up as the company has fought against the notion that active managers can add value consistently.
Research Affiliates sent me an article that has a different view. It says SmartBeta is rapidly displacing traditional stockpicking. It argues that many strategies have persistently outperformed market-cap-weighted benchmarks. It recommends a SmartBeta strategy to be diversified across factors, and to rebalance frequently between portfolios, reducing exposure to popular factors that have outperformed and increasing the holdings in unpopular factors.
If you have an adviser who is up for complexity, he can add further value by dynamic rebalancing using things only hardcore CFA nerds understand, such as short-term momentum and long-term reversal signals.
INDEXING IS OWNING THE MARKET AND FUNDAMENTAL INDEXING IS BETTING AGAINST THE MARKET. IT BELONGS IN THE ACTIVE BUCKET