The Dark Side Of Smart Beta
There’s no such thing as a free lunch on Wall Street. When a widely available investment strategy is expected to generate an excess return over the broad stock market, by definition it has additional risk and cost embedded in it. So-called Smart Beta strategies fall into this category. The term may sound like a better mouse trap, but there’s a dark side.
The Smart Beta marketing slogan has become a catchall for any quantitative investment strategy that is mechanized into an index and sold through mutual funds, exchange-traded funds and separate accounts. Those methodologies may select securities using fundamental stock data for screening or weighing stocks based on factors other than capitalization, or both.
A strategy can be as simple as equal weighting the stocks in the S&P 500 rather than using the traditional capitalization weight index or complex multi-factor strategies that dig deep into quantitative and momentum factors.
Smart Beta was “the” topic an Inside ETF conference I attended. I was approached by three journalists at the event who asked my opinion. This was my answer.
The marketing of Smart Beta strategies leaves much to be desired. The truth is not being told. The unexplained risks and costs in the strategy have been hidden by industry hype.
Investing in Smart Beta strategies has three shortcomings relative to investing in a low-cost total stock market index fund. They are:
- Higher cost
- Higher risk
- Extended periods of underperformance
Higher cost: The total cost to investing in market-tracking total stock market index funds is dirt cheap. In fact, I like to say that beta is essentially free. The capitalization weighted Vanguard Total Stock Market ETF (ticker: VTI) has an net expense ratio of 0.05% and has very low securities turnover. Investing in the market doesn’t get much cheaper. In contrast, the fundamentally weighted PowerShares FTSE RAFI US 1000 Portfolio (ticker: PRF) has a net expense ratio of 0.39% and significantly higher portfolio turnover. This is due to the quarterly rebalancing needed to adjust the fundamental weighting of stocks. PRF’s higher fee plus frictional trading costs have to be paid every year before any investors earn any excess return in the fund. To be fair, Invesco PowerShare ETF fees are lower than most competitors. Some Smart Beta funds have much higher fees.
Higher risk: When an investment strategy is created for the mass market, and that strategy is expected to generate a higher return than the market, it can only be a result of higher risk. There is no free lunch for everyone that shows up in the serving line. That would defy the laws of economics. We can’t all be above average.
Investors who buy into Smart Beta strategies are simply putting more risk in their portfolios than a simple market beta alternative. The risks may be from overweighing small-cap stocks, reducing the number of stocks in a portfolio, or value stock tilts, or a combination of many risk factors. Regardless of how it’s defined by Wall Street, Smart Beta means higher risk than a comparable market portfolio.
Extended periods of underperformance: Smart Beta strategies are not infallible and this fact even shows up in the hypothetical back-testing that’s done before a product is launched. There have been long periods of time when these strategies have underperformed the market.
In a recent blog, Smart Beta and Tourist Investors, I highlighted an 18-year period of time when small-cap value stocks underperformed the total stock market. Even if the long-term data shows that these strategies have outperformed in theory, the risk of prolonged negative tracking error is that many less-informed investors will not have the patience to survive the drought. Capitulation during underperformance will lock in below-market returns.
It’s a big problem if fund companies and advisers start taking shortcuts by substituting slogans like Smart Beta for comprehensive investor education. Unfortunately, that’s what I'm seeing. The product providers are selling the sizzle rather than the steak. Investors are treated unfairly when they’re told a strategy is smart without full understanding of the additional cost and risk, and they’re likely to sell when the strategy underperforms the markets. That would permanently lock in below-market returns, and that’s not smart.
I’m not against factor investing; I’m just against the way it is being sold by some product providers. There is no substitute for real investor education. There can be no misunderstanding of the costs, risks, and the long periods when underperformance has occurred in the past. That’s the only way an investor will have the discipline to stay the course when everything is moving in the opposite direction. It may take a lifetime before an investor profits from these strategies, if at all. They need to stay the course.
Smart Beta is not a panacea that provides unlimited supplies of excess return without extra risk. That’s not the way things happen on Wall Street. If you’re not ready for a lifelong commitment to this strategy, then it’s not for you.